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 Samik X. Chatterjee - JPMorgan Securities LLC Jeffrey Thomas Kvaal - Nomura Instinet George C. Notter - Jefferies LLC Rod Hall - Goldman Sachs & Co. LLC Jim Suva - Citigroup Global Markets, Inc. Simon M. Leopold - Raymond James & Associates, Inc.

Tim Savageaux - Northland Securities, Inc. Meta A. Marshall - Morgan Stanley & Co. LLC.

Welcome to the second quarter year 2018 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, Andrea. Welcome to Infinera's second quarter of fiscal 2018 conference call. A copy of today's earnings and CFO commentary are available on the Investor Relations section of our website. Additionally, this call is being recorded, and will be available for replay from the website.

Today's call will include projections and estimates that constitute forward-looking statements. Including statements about our business, plans, products and strategy as well as statements about our pending acquisition of Coriant.

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 second quarter earnings release and CFO Commentary. I'll now turn the call over to our Chief Executive Officer, Tom Fallon..

Good afternoon and thank you for joining us on our second quarter 2018 conference call. Joining me today are Brad Feller and Dave Welch. Today, I will review our performance in the second quarter, provide commentary on recent wins and future opportunities, and cover progress on our pending acquisition of Coriant.

I'll then turn the call over to Brad who will provide a more detailed financial review of our outlook for the remainder of the year. I was very pleased with our financial performance in Q2 as we delivered strong results relative to guidance, including our fifth consecutive quarter of sequential revenue growth.

Revenue of $208 million was up 18% year over year and 3% sequentially off an extremely strong first quarter, driven by strength from our cable customers and growth from our Tier 1 customers in all regions. In Q2, our ICE4 products continued to be a significant contributor to sequential growth and grew again as a percentage of our overall revenue mix.

ICE4 products were also key in lowering our internal cost structure and driving non-GAAP gross margins of 44% at the top of our guidance range. As a reminder, our unique vertically integrated operating model enables us to sustain a relative margin advantage with each new generation of ICE technology.

I'm pleased that we completed our full ICE4 product release in Q2 starting to ship our 2.4 terabit XT-3600 for revenue. Similar to our experience with ICE 3, my expectation is that revenue from ICE4 products will grow for many years with steady cost structure improvement as we ramp volume.

In Q2, we converted several ICE4 opportunities to revenue with our AOFX-1200 enabling our customers to seamlessly add significant capacity to their networks with simple card swaps. Based on a solid trial activity, particularly with service providers, we anticipate strong growth from ICE4 products will continue in the second half of 2018.

These successful product launches are a key factor in our positive outlook for the second half of 2018 and beyond. Before we move on to more detail on the Coriant acquisition, we're going to spend some time highlighting some major new customer wins that will drive strong multiyear revenue.

These wins demonstrate the differentiation of our technology and customer receptivity to our refreshed product portfolio. Coming off a robust first half and armed with a deep pipeline of new opportunities, we are entering into this acquisition with strong momentum.

In subsea, we had a record bookings quarter in Q2, which given longer relative deployment cycles in subsea, bodes well for market share and revenue in upcoming quarters. Having recently set the leading capacity benchmark on a transatlantic subsea fiber link, our ICE4 technology is proving compelling to subsea customers.

On this front, we are on track to deploy a significant subsea and long haul ICE4 network with a significant Tier 1 in Asia. This was a competitive displacement and a clear example that Infinera's low total cost of ownership value proposition resonates in markets globally.

This customer has embraced open architectures, loves the ease of use of our solutions, and will utilize Instant Bandwidth which provides the ability to match the capacity they buy with current demand on their network. We have plans of deploying this footprint in Q3 of 2018 with capacity additions expected in 2019 and beyond.

With our CX2, we recently won our first major deal with a global financial enterprise for deployment with Instant Bandwidth. Additionally, we recently won a sizable footprint expansion with our largest ICP customer that will deploy in Q3.

Finally, in metro, an update on the opportunity stemming from the deregulation of fiber access in the UK that we highlighted a couple of quarters ago.

SSE Enterprise Telecoms has begun a major nationwide project targeted at the UK business connectivity market, deploying a packet optical network backbone that will unbundle a 177 incumbent BT exchanges to deliver high capacity services on its own fiber.

Towards this initiative, we have won a major new build with SSE that will begin deployment in the third quarter of 2018. Having displaced the traditional incumbent, this new win is an important proof point of the low latency and scalability of XTM II for metro edge applications.

More broadly in metro edge, we continue to be well positioned to address significant fiber-deep opportunities with some of the largest cable operators in the world. Fiber-deep represents a multi-billion dollar, many-year architectural change.

While it isn't clear when the deployments will begin in earnest, we believe we are well positioned with a unique approach and offering. With the addition of the Coriant capabilities around 5G and the metro, we believe we will be well positioned to attack both demand drivers of the fiber-deep initiatives.

In addition to these recent wins in footprint deployments, we have a solid pipeline of future opportunities that position us to drive growth and take share. In Q2, we had 38 combined ICE4 and XTM II trials and have booked 19 Open ICE trials thus far in 2018.

Exciting to me is that nine of these Open trials are with prospective new customers, supporting our belief that Open breaks down the barrier of incumbency and creates Infinera transponder opportunities on previously deployed competitor line systems.

My expectation is that we will convert several of these current ICE4, XTM II and Open ICE trials to revenue in upcoming quarters.

Also, regarding future opportunities, I am pleased that we are seeing a significant expansion in demand from Instant Bandwidth, as evidenced by more than 50% of our ICE4 units projected to ship in the second half being Instant Bandwidth enabled versus 20% over the past year. Instant Bandwidth is unique to Infinera, and customers clearly love it.

We view this as much more significant than the logical pairing of supply and demand. It is the beginning of a real transformation to software-defined reconfigurability. As a reminder, future revenue from Instant Bandwidth license capacity comes at software-like margins.

Given the increase of ICE4 product capacity from 500 gig to up to 2.4 terabits and the growing percentage of Instant Bandwidth enabled products, we are considerably increasing the pool of high-margin license revenue available across our installed base, which should benefit our bottom line in future periods.

All in all, our fully refreshed product portfolio is driving important new customer wins and significant footprint expansion that will drive revenue for the next several years. Further, footprint wins today lock in higher margins a few quarters out as customers add capacity into the Infinera network.

For these recent wins, we expect to see higher margin contributions over the course of 2019 and 2020. Now turning to our recent announcement of the Coriant acquisition, customers, suppliers and employees have been overwhelmingly supportive.

They see the strategic logic and the unique benefits Infinera can derive from greater scale and significant customer base expansion with Tier 1s and ICPs. I believe that Infinera will realize unique value from acquiring Coriant in a number of ways.

First, we're the only company in the industry that can fully leverage vertical integration to structurally raise Coriant's margins. We did extensive diligence in this area and are confident of both our technical ability to execute and the step function margin impact that will occur when complete.

In addition, not only do Coriant's products' gross margins benefit from vertical integration, but increased volume running through our fab lowers the cost structure of the entire company.

Next, the Coriant product portfolio is very complementary to ours adding additional capabilities around mobile, automation and Layer 3 that should open significant opportunities for us moving forward. Finally, Infinera is the only large scale optical system company with such minimal overlap of major customers.

With this acquisition, we significantly expand our Tier 1 and ICP customer set, as well as enhance the overall global presence of our business while significantly improving our revenue diversity. While our logic for the deal seems clear to most, I'd like to spend some time on our plans for integration.

We intend to act immediately to integrate post-close. A successful execution of integration activities over the remainder of 2018 will be crucial towards achieving growth and synergy targets in 2019 and beyond. First, we are reaffirming our synergy targets of $100 million in 2019 and an additional $150 million by 2021.

Keep in mind that the expected $250 million in total synergies, 40% are attributable to vertical integration, specifically our plans to integrate our optical engine into Coriant's platform starting in 2020. The additional $150 million expected in 2019 and 2020 stems from bottoms-up OpEx savings and supply chain related COGS synergies.

This $150 million represents less than 10% of the combined company spend. The overall synergy plan has three main vectors.

Optimizing resources and processes across SG&A, executing on the scale advantage of supply chain savings in both service and manufacturing and the cost avoidance of forward R&D development while leveraging our vertical integration across Coriant platforms.

Second, we have a robust integration plan that will be fully staffed and professionally supported with proven, experienced integration resources. We have established a plan with 14 specific work streams to accomplish the full integration of the companies.

We are staffing the effort with a coterie of full-time, 100% dedicated proven folks from integration team members from Infinera, Coriant, and the industry. And with key capabilities of Oaktree, we will leverage resources from proven professional firms for each phase and stream of the integration.

Third, on the customer front, upon closing we will develop win plans for certain large in-progress opportunities where the customer would benefit from our combined suite of capabilities.

As we discussed earlier, we've had a strong response from our customers since the announcement of this deal and have not baked any revenue synergies into our deal analysis.

Lastly, given we are limited in what we can do and share before the deal closes, we intend to provide a deeper dive into our integration and product portfolio plan at our Analyst Day, which will be scheduled for the fourth quarter of this year.

In closing, having spent the past two weeks talking to customers, suppliers, employees and investors about acquiring Coriant, I feel even more optimistic that this is an incredible opportunity for Infinera and our shareholders.

Doubling our revenue gives us the scale to benefit more substantially from vertical integration, enhancing our ability to consistently deliver differentiated margins. We are further benefited by our increasing ability to deliver a more comprehensive suite of solutions to both our existing customers and the expanded base of Tier 1s and ICPs.

We are entering into this acquisition from a strong position. Our fully refreshed product portfolio is driving revenue growth and earning Infinera new customers, with expected footprint expansion in the second half of 2018. I really like our position and couldn't be more excited for what the future holds.

I'd like to thank our customers, partners, and shareholders for their ongoing commitment to Infinera and an extra thanks to our employees for their hard work. I will now turn the call over to Brad to discuss the financials..

Thanks, Tom, and good afternoon, everyone. Today I will discuss Q2 highlights, share some color on our future outlook, and provide additional commentary on the Coriant acquisition. The detailed recap of our Q2 results is available in the CFO Commentary on our Investor Relations website.

Please note that unless specifically stated, all numbers and guidance provided today are on an Infinera standalone basis. In Q2, revenue was $208.2 million, up 3% sequentially and 18% year over year.

Growth in the quarter was driven by strong international results, highlighted by revenue in APAC growing more than 100% sequentially due to both a spending increase from a large Tier 1 and ICP growth in the region.

Looking at customer verticals, our cable business remained robust and we saw encouraging growth in Tier 1 spending across all of our regions, stemming from the adoption of ICE4 products.

In Q2, existing customers invested substantially in the AOFX-1200, our upgraded DTN-X linecards, allowing them to leverage existing infrastructure to add capacity cost effectively for them and at attractive margins for us. With accelerating new product momentum, we expect to see continued growth in the second half of 2018.

Consistent with our outlook from last quarter, we continue to expect revenue in the second half of 2018 will be 2% to 4% higher than the first half. This implies a revenue range in the second half of approximately $420 million to $430 million, which at the midpoint represents 13% year-over-year growth for the full year.

For the second half, we anticipate growth will be driven by continued adoption of new products with existing customers and large initial deployments with new customers. As Tom noted, we have substantial opportunities for new deployments of ICE4 and XTM II solutions across multiple verticals and regions in the second half.

As a result, we currently expect Q3 revenue of $210 million plus or minus $10 million. At the midpoint of this range, this represents 9% year-over-year growth.

We are guiding to a wider revenue range than typical in Q3 due to the timing of some of these deployments being on the cusp either at the end of Q3 or beginning of Q4, making it difficult to predict in which quarter revenue will be recognized.

I'm very pleased that we expect growth from the broader business in the second half of the year to offset an expected seasonal deceleration in cable, which comes off an exceptional first half, where it accounted for over 30% of Infinera's revenue.

In summary on revenue, we are pleased with our performance in the first half and are very excited about the multiyear opportunities we have won that we'll begin to deploy in the second half.

For the rest of the year, we remain focused on winning additional new customers, and with the addition of Coriant's customer base and capabilities, accelerating our growth momentum into 2019. Now turning to margins, non-GAAP gross margin in Q2 was 43.9%, at the high end of our guidance range of 40% to 44%.

This strong result was attributable to several factors, including new products continuing to increase as a percentage of the revenue mix, strong Instant Bandwidth license sales, and the deployment of certain footprint deals shifting from Q2 to Q3.

This result demonstrates the strong potential of our business model, which enables better than industry gross margins. Specifically, as our revenue mix continues to shift to new products, we enjoy the benefits of the significantly lower cost structure enabled by our vertically integrated business model.

Also, there's a favorable margin impact with our Instant Bandwidth model when customers grow their networks with capacity licenses, as we saw in the quarter. We see increasing benefit from Instant Bandwidth with ICE4, as on a per-unit basis we are able to deliver a 2.4x increase in capacity at nominally the same cost.

With the higher capacity that ICE4 delivers, the amount of pre-deployed licensable capacity extends considerably at software-like margins for Infinera in the future. Being able to deliver nearly 44% non-GAAP gross margin in Q2, while deploying a large amount of Instant Bandwidth-ready equipment is truly a strong result.

Looking ahead, we will continue to be aggressive toward winning new customers, utilizing our new technology, balancing topline growth and profitability.

Coming off an exceptional gross margin result in the first half of 2018 combined with our outlook for the second half, we expect non-GAAP gross margin will be in the range of 41% to 43% for the full year, in line with the plans laid out earlier in the year, amongst the best in the industry, and with margin expansion exiting the year.

In Q3, due to the high number of new footprint wins we anticipate deploying, we currently project non-GAAP gross margin will be 36% to 40%. This gross margin is indicative of several new network wins that carry relatively low initial margins but also high-margin bandwidth fill in future quarters.

To put this in into perspective, in 2018 we have prioritized winning new footprint and overall share with the willingness to be aggressive to secure certain deals.

While footprint deployments tend to result in lower margins in the near term, the new business we have secured will drive multiyear revenue that is increasingly profitable, given the combination of high-margin fill capacity, the lower-cost structure enabled by our vertical integration and the software-like margins of future Instant Bandwidth licenses.

Given the significant opportunities for growth going forward within these networks, we are confident that these deals will drive improvements in our overall profitability, driving us towards our longer-term financial goals.

Turning to OpEx, non-GAAP operating expenses were $92.8 million in Q2, down from $95.4 million in Q1 and slightly lower than the midpoint of our $91 million to $95 million guidance.

In the quarter, we continued to balance investments in future technologies and lab trials to support customer adoption of our new products with the cost reductions we committed to as part of our late 2017 restructuring.

For the remainder of the year, we plan to exceed the commitments we made as part of our restructuring plan and exit 2018 with overall quarterly operating expenses well below $90 million. In Q3, now that we have completed our portfolio refresh, we project OpEx will decline sequentially to be in the range of $84 million to $88 million.

My expectation remains that R&D will be the main driver of this decline. G&A costs will decrease slightly and sales and marketing expenses will be dependent on our revenue performance. Looking ahead, we will continue to balance driving operating efficiencies with investments to support revenue growth and drive customer adoption of our new products.

Entering next year with a combined revenue of approximately $1.6 billion, I'm excited that we will have the scale to drive significant operating leverage while also investing sufficiently to deliver differentiated technologies at the pace the market demands them.

We are demonstrating strong financial leverage in our operating model as evidenced by the following non-GAAP metrics. In Q2 we grew revenue 18% while increasing gross profit approximately 27% and reducing operating expenses by 1%, leading to a $20 million increase in operating profit year over year.

And for the full year, we expect to grow approximately 13% while increasing gross profit by approximately 20% and decreasing OpEx, leading to an improvement in our operating profit of over $60 million year over year.

In Q2, on a non-GAAP basis, we had an operating loss of 0.7% and a net loss of $0.01 per share, with both metrics above our guidance range, largely due to strong gross margin.

On a GAAP basis, we incurred a net loss of $0.14 per share with stock-based compensation expense being the largest driver of the difference between our GAAP and non-GAAP results.

For the second half, we anticipate revenue growth and prudent expense management will enable us to return to non-GAAP profitability in the fourth quarter of 2018, consistent with the outlook provided on our previous earnings call.

In Q3, due to the lower initial gross margins of our new footprint wins, we project a non-GAAP operating loss of approximately 3%. Below the line, given that we paid off our convertible debt, we expect interest expense to be negligible for the time being. To finance the pending Coriant acquisition, we are closing in on securing new debt.

Future interest expense will depend on this debt financing. Also, as a reminder, on a stand-alone basis, our significant NOL balance in the U.S. will drive our tax expense for the foreseeable future on a stand-alone basis to be approximately $1 million per quarter. After the deal closes, we intend to share our tax outlook for the combined company.

In Q3, we currently project a non-GAAP net loss of $0.05 per share plus or minus a couple of pennies, with the GAAP results $0.11 lower mainly driven by stock-based compensation and based on today's share count.

Given our expectation of higher revenue and improved gross margin in the fourth quarter, we expect to record positive non-GAAP net income in Q4 2018. On the balance sheet, as the business continued to build momentum in Q2, I was pleased that we generated $7 million in cash from operations.

Excluding the cash outflow related to the payoff of our $150 million convertible debt facility, overall cash and investments declined in the second quarter by $9 million as positive cash from operations was offset by currency impacts and CapEx related to investments, related to support next generation technologies.

In conclusion, our top-line growth and bottom line improvements demonstrate the market's receptiveness to our refreshed portfolio and the earnings potential of our vertically integrated business model.

We have prioritized customer and footprint expansion in 2018 and expect to reap the revenue and high margin benefits of this strategy in 2019 and beyond.

We are in a good spot armed with a strong pipeline of Infinera opportunities over the next several quarters and with Coriant's complementary customers and capabilities, we are well positioned to grow as a combined company.

As a combined company, we also stand to benefit substantially on the bottom line, profiting early on from scale and its associated operating leverage and a few years out from leveraging our vertical integration across Coriant's platforms. Like Tom, I like where we stand.

We are poised to deliver strong financial results in the second half of 2018 and a differentiated highly profitable financial model over time. With that, I'd like to turn the call over to the operator to begin the Q&A portion of the call..

We will now begin the question-and-answer session. Our first question will come from Vijay Bhagavath of Deutsche Bank. Please go ahead..

Thanks. Hey, good afternoon, good to follow the results here. A question for you, Tom, in terms of both cloud and metro.

Where are we today on this speed transition optical capacity upgrade cycle? Roughly what visibility do you have, one plus quarters hopefully? And then as we head into next year, how do the speeds kind of transition? Like are we currently in 400 gig optical land moving to terabit scale? So help us understand the speed transition and also visibility in your business, cloud and metro.

Thanks..

Okay, Vijay. So I'm going to break this up into a couple parts. One is around visibility and opportunities. Then I'm going to ask Dave to talk about speed transitions in the various markets. So first of all, I think that in the cloud is being very well received ICE4.

Since we introduced it last year, we've won a lot of customers and a lot of customers have upgraded. I'm really excited that we've finally broken into the financial markets with our CX. We've been working hard to get into that area for a while.

I think the hardest part of the financials is that they tend to be risk averse around trying somebody who doesn't have a marquee. We'll now have a marquee. So I think that the ease of use, the fact that we provide so much Instant Bandwidth capacity, the quality of the program, I think we have a really great opportunity.

Looking forward to the rest of the year in cloud, I see probably kind of steady business. It's a little bit of a lumpy business, not only for us, but the entire industry. But clearly, there's continued expansion of cloud in not just ICP, but data center to data center. And I feel like the ICE4 has been well received and we have good opportunity.

In metro, I'm actually more and more optimistic around our position in metro. First, as we talk about SSE. That's a really, really substantive win. When we talk about breaking up the BT lock on internet access in the UK and SSE going after that with us, displacing an incumbent.

Clearly the low power, the ease of use, the density of the program, really went against everybody and we opened that door, and I think it's going to be a very long program for us that will be very, very good over time. And once again, it's a new benchmark in the industry where we can go leverage that. So I'm excited about metro.

One of the things that I am also excited about metro is the Coriant acquisition will give us a very good metro core. And it's very complementary to what we get with the XTM. The XTM is more of an access edge play, and when you're looking about power, cost, density, it's a clear leader.

When have you to go into integrated switching, when you go into redundant control, the mTera will be a great complement for that. So I think it opens up a big opportunity as the metro core continues to expand. And then clearly in the metro, 5G and fiber-deep are going to be the big plays over the next several years.

I think we were well positioned before. As we add the Coriant portfolio, particularly of their new Vibe capabilities, and the rest of their portfolio around automation and SDN, I think we will have an incredibly compelling solution.

When that really starts, I'm not sure, but it's going to start sooner rather than later and it's going to be, I think, quite large. And I do think we are well positioned both from a technology perspective, but also now with a customer perspective. Dave, if you could answer Vijay's question on speed transitions, I'd appreciate it..

Sure. The speed transitions that are going on in the network. Right now you have to break it down into edge, access and metro core and then into long haul. At the edge, the transition is going to happen over the course of the next few years.

It's going to be the transition from 10 gigabit to 100 big gigabit, and that is probably certainly the largest volume in the impact as the edge access – edge and access speeds drive up. As far as going into core, currently the majority of the bandwidth that's deployed right now is being deployed at 200 gigs a wave. That certainly will go up.

But the spectral efficiency isn't going to make any transition there. It's all about dollar per gigabit. So whether it goes up to 400 gigabits or whether it goes up to terabit class, that will be driven not by service speeds, but more by dollar per gigabit capability. The DCI, where you have a high concentration, the transition of 400 gigs ER types.

That's a 400-gig coherent. I think that market is going to be split between the 400 gig and the terabit. So it will be driven by what the advantages are for dollar per gigabit basis, between the two. And that's probably more set for a 2020 type of transition time..

Thank you. That was very helpful..

Thanks Vijay..

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

First, before I ask a question, could you just clarify your comment on trials? I think you said 38 trials, then you also went on to say there were 19 Open ICE trials. Is that 38 plus 19, or is that 19 in the 38? If you could, just clarify that..

That 19 is in the 38, Alex. I'm pushing both trials of new products. They're new customers, they're old customers with new technology, and there's Open, which is typically or often, as we said, nine of them have not historically been Infinera customers.

So I'm quite frankly excited about all the trials, and I think it speaks well to our opportunities over the next several quarters. Open to me is strategically important..

The primary question I wanted to ask was around the gross margins. I think you said the second half product gross margins would be in the 36% to 40% range, and I think that probably ties to the very high percentage of ICE4 products going out with Instant Bandwidth at 50%.

First off, am I correct that that's – you're putting out a lot more capacity than you're charging for.

It does give you an opportunity in the future, but is that the primary driver of that margin pressure, or alternatively, are you being more aggressive on system and integrated all-in costs to gain footprint? Can you distinguish between those two factors?.

Sure, Alex. Just to clarify one thing, the 36% to 40% is just Q3. The metrics for the second half are higher than that. And it's a combo of what you described. It is truly new networks going out that are very lightly loaded, both from a traditional sense and also from an Instant Bandwidth sense.

So there will be a lot of additional high-margin bandwidth to be added to those as we go forward. A lot of those are obviously new customers and new opportunities where there's also the incremental new footprint infrastructure that goes in day one.

So we have a large amount, as Tom mentioned in his script, new customers and new deployments that are coming, and the combo of them being lightly loaded, and that infrastructure is putting pressure on the Q3 margins..

Alex, let me add one thing. As you think about the PIC going from 500-gig to 1.2-terabit, that leaves a lot more ability for customers to add incremental bandwidth over time. Our installed base of fillable I-Bandwidth grows dramatically.

As we win these new customers, and we're winning more than we have now that we have our full ICE4 portfolio out, a large percentage of them are now buying with I-Bandwidth. I think in our script, we said half in the second half of the year, as I recall, which is up substantially from what we had historically done. I think that's great.

We're using I-Bandwidth to lower the customer's first-in cost. That is a critical buying decision, is first-in cost. Then for no incremental cost, we basically got them locked in for years of capacity expansion. So I-Bandwidth as a percentage going up is important.

The fact that the PIC capacity is more than double is important, and the fact that we're winning new footprint. The one in Asia that we won is a substantive rollout in Q3. SSE starts to roll out in Q3. We've just been given a letter of intent for another Tier 1, a new customer for us, down in LatAm that will open up in the second half. Maybe not Q3.

We'll see if we can deploy it by then, but in the second half. It will also be I-Bandwidth. And interestingly enough, it's a customer that started out in the lab because we have Open ICE. And we've been certified now across all their vendors' amplifier systems. So we're winning footprint.

It comes at a cost, but mostly the dynamics are very positive in regard to why Q3 margin is under a little bit of pressure..

Just to be clear and paraphrase what I think I'm hearing you say, this is mostly Instant Bandwidth and lightly loaded, not a function of a step up in aggressive pricing for the aggregate system that would cause industry-wide price pressure..

It's not a step up in pricing pressure. We are seeing probably a disproportionate of new footprint wins and deployments in Q3..

Alex, I think you characterized it exactly right, which is it's not a new aggressive, it is us putting out pre-deployed capacity into new networks that's putting a little bit of pressure..

Great, that's very helpful clarification. Thank you..

Thanks, Alex..

Our next question comes from Samik Chatterjee of JPMorgan. Please go ahead..

Hi, thanks for taking my question. I just wanted to follow up on the Instant Bandwidth question, the last question, and get a feel of when you mentioned you're deploying Instant Bandwidth with your customers, increasingly at or probably an increase in attach rate, and you're lightly loading it, so the margins are lower to start off with.

But what is the typical customer behavior you've seen in terms of then opting for an upgrade in terms of the bandwidth, which comes in at a higher margin at a later stage? What are you seeing in terms of timeline and typical customer behavior? When do you expect that high-margin bandwidth to be purchased later?.

It's different from customer to customer. But if you look at the types of customers we're talking about, these are large Tier 1 customers that increase their capacity very rapidly. So we expect it to start to come within a couple quarters of those initial deployments..

I think that the first couple of quarters is really spent deploying things and turning things up. And as they start deploying services, the beautiful part was for them, a lot of these carriers to go into a new region have to justify going into that region with a very fast return of capital.

When the Instant Bandwidth infrastructure is already deployed, they can very easily put out very small amounts of incremental CapEx to open up new markets. So we have found that for the larger carriers, the adoption is actually fairly fast.

The other thing that is important to understand as an investor, when we sell a fully loaded unit versus an Instant Bandwidth loaded unit, over time our margin on the Instant Bandwidth loaded product is actually better. That's part of how we pay for it. We are financing it, and I think that it works great for our customer.

It also works great for our shareholder. And the great part to me is once you have that infrastructure in place, that next 100 gig is coming to us because it's the cheapest, easiest, fastest way for our customer to deploy that next 100 gig..

I'm going to add on a comment here. I want to make sure that the value of Instant Bandwidth, it is more valuable to the customer because of the reconfigurability that the Instant Bandwidth enables them in their marketplace. And then I've seen this in many of our customers.

Tom has spent mostly on the financial side talking about the ability to turn on and align with their revenue stream.

There's an added value on there that we get highly significant upside from is that a licensed network can be reconfigured instantaneously for that as their patterns demand or if a catastrophic event has happened, it allows them to move those licenses around to where the system is operational, and that adds a significant amount of value to them.

That's a primary reason why the margin for this capability is higher..

It's really – and Dave talks about this a lot around, the industry's talking about network automation. This is a real use of network automation. Today I have capacity from point A to point B that I bought. Tomorrow I need it from C to D. With our Instant Bandwidth, you actually just move the license to C to D. You don't have to do anything else.

We're really working hard to create network as a utility, and I think that we're the only people that have the toolbox to bring that to life..

This is as close in the transport world as you can get to a software-as-a-service. It's a bandwidth-as-a-service capability, bandwidth-on-demand, and that has significant value to them..

Thank you..

Got it. Got it. And I have a quick follow-up on – sorry, I had a quick follow-up on the operating expense guidance.

Going from Q3 where you're guiding to $86 million into Q4, is sort of the $86 million be cost structure for the stand-alone business that you're expecting to move into the integration with, or are you looking to drive expenses down further in Q4 before you move into the integration?.

Yeah, so there's not another step-down from there. In fact, it may be a titch higher than the $86 million, just with some year-end sales comp with the strong Q4 that we're expecting..

Okay. Thank you. Thanks..

It's important to realize that we committed, I think, the $40 million of costs to come out of that business this year, and we're on track to achieve that..

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

Thank you all. Let me start actually with a follow-up, which is following up from last quarter, you had talked about some intensifying pricing pressure. It doesn't seem like things are as intense this quarter.

Does that mean things have reverted to where they were a quarter ago? Or just haven't gotten any worse?.

You should assume that I communicated very poorly last quarter. This industry always has price competition. I wasn't implying that it's getting worse than that. My indication was that on new footprint that it's becoming even more intense on new footprint and that's no change on that. To me, it was trying to be fully disclosing on what we see.

My take is on new footprint. We come armed with an arsenal of tools that actually allow us to price aggressively with things like Instant Bandwidth and make a fair return over time, but the aggressiveness upfront, it's significant.

That's one of the reasons you're seeing, as we talk about, some of the compression in Q3 because a lot of that is new footprint. The best indicator in my mind of our future opportunity is how much footprint we're deploying, both with current and new customers. So it's not something that we lose a lot of sleep about. We're not walking away from deals.

We're going to go aggressively pursue deals where we can make a fair return over time, and we have a toolbox that will allow us to do that..

And, Jeff, just to clarify, I think Tom has clarified this before, if you had any one of those deals, it's very normal. The fact that you have multiple of them that we're winning at the same time, that's where it puts the extra pressure on the margin side..

What makes me scratch my head a little bit, gentlemen, is that we're now deep into the ICE4 cycle and yet the gross margins, and let's average them across a couple quarters, not get caught up on the third quarter, but let's just say that they're in the low 40s.

Even though we're deep into the ICE4 cycle, and I would have thought if you had asked me a year ago that the margins would have made significant progress from the low 40s.

So what's happening here? Is it the Instant Bandwidth is becoming a more popular business model than you had expected? Or how should we think about that?.

Yeah, so, Jeff, the biggest thing that you've got to realize is we've just launched the AOFX-1200 and really just launched the XT-3600. So we've talked about historically that about two-thirds of our customer base use primarily those products.

So I would say we're deep into ICE4 that CX and the baseline XT-3300 have been out for a good period of time, but the AOFX-1200 and XT-3600 are still a very small portion of the overall piece. So, you will see that continue to grow. We talked about it being north of 30% of product revenue.

You will continue to see that grow over the course of the year and into future years. That's when you really start to see the power of the cost structure as we go forward..

Okay. We'll follow up on that, Brad. Thank you very much..

Thanks, Jeff..

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

Hi, guys. Thanks very much.

I guess I wanted to jump in here and just make sure I understand kind of what you guys are looking for in terms of your largest customer, obviously its CenturyLink Level 3 historically, and one of the narratives I think around the business was that that customer would improve over time as you kind of get past the merger integration there.

I guess I'm curious if you're seeing improvement in run rates with them? And then also I know there's an RFP process. What are you expecting in terms of that RFP process as you kind of think about second half guidance? And just in general, how much does that improve your opportunity going forward? Thanks..

Yeah, certainly, George. I would say that CenturyLink revenue we're seeing now is up slightly from what it bottomed out as. We are still not forecasting any fundamental change in that. So there's a significant gap from what it was running at, to what it is running at. The good news is every quarter we have become more successful at replacing that.

Clearly, if that goes back to anywhere close to where it was before, that's a significant upside. We just aren't baking that into our near-term planning because we don't know when that's going to occur. My suspicion is it will occur. In regard to the RFP, we continue to monitor and track that. We're hopeful that a decision will be made in Q3.

I think that we are well positioned but I certainly am not going to count my chickens before they hatch. We've had a long relationship, a very good relationship with both companies. We're the incumbent for long haul at both companies. Coriant has a substantive metro base, certainly at part of the old company. So I think we're well positioned.

We're going to go – we've worked very hard to earn this opportunity and I think that there will likely be a decision likely in Q3..

Okay. Good luck. Thanks very much..

Thank you, George..

Our next question will come from Rod Hall of Goldman Sachs. Please go ahead..

Yeah, hi, guys. Thanks for the question. I guess the first question I want to ask is you've got these footprint wins in Q3 and yet the revenues are pretty flat quarter on quarter.

So just wondering is that because other revenues deteriorated? Or is there something that I'm making up in terms of how the revenue ought to flow? It seems like you ought to have higher revenue to go along with the weaker margins but I'm not sure about that so I wanted to ask. Then I've got a follow-up..

Yeah, so, Rod, the piece in the second half that we've been talking about for a while was that cable in the first half was exceptionally strong, as is traditionally in that space, and we had our largest customer roll out very aggressive plans in the first half. So we had anticipated that that was not going to continue into the second half.

So what you see is these new opportunities both with new customers and ramping with AOFX-1200 and XT-3600, helping to backfill that, which is why you don't see the top line growing more significantly..

Okay. And then I guess I'm going to roll this into one follow-up. But my understanding, we get that the Instant Bandwidth depresses margins.

Is there any way you can give us, Brad, some kind of indication of how much revenue that was, so that we could sort of get a feeling for the math behind it? And then I also just wondered is it the way – it's a much bumpier margin trajectory exiting the year than we would have expected. We're calculating like 42.5% gross margin in Q4. I wonder.

Is that what you guys expected originally, or is it a little bit more lumpy on the gross margins than you thought it would be?.

Yeah, Rod, it's hard to get into the real detail behind every deal on the call itself but we can work towards that offline. But in terms of your question about the lumpiness, I would say we had good anticipations of winning additional customers.

We've been very focused on it but as the year's rolled out, quite frankly, we've been more successful than we anticipated and that has put a little bit more variability into the margins.

The thing I will tell you, though, and ask you to focus on is the win rate is significantly higher than we expected and the long-term revenue opportunity is also bigger than we expected..

And just one comment on these roll-outs of new footprint. Once a network's installed, it's much easier to get into a cadence of revenue and planning with the customer. New footprint there at the power availability, fiber availability, they have all kinds of facility they have to work with and it's not unusual for those to move out.

It's very unusual for them to move in. One of the reasons our Q2 margin was at the very high end of our guidance range is some of the footprint we had actually anticipated in Q2 rolled to Q3. So Q2 was a little higher. Q3 is a little lower than we would have thought. Net-net it's about the same over a period of time.

I think it's important not to focus on any type of quarterly variation because footprint wins really do move the needle of margin. And I think integrated over a period of time, I'm actually pretty comfortable with our margin expansion..

Great. Okay. Thanks, guys..

Our next question comes from Jim Suva of Citi. Please go ahead..

Thank you very much and congratulations on the results as well as the gross margin. In your prepared comments, you made a reference to some recent new wins. I think you said that some of the telecom companies have had a....

Jim, you're coming through unfortunately pretty garbled, and I can't understand the question..

Is that better?.

I think so, yes..

Congratulations on the results and the gross margins..

Thank you..

On your prepared remarks, you mentioned that you had some recent wins at I think telecom that had an adverse impact to gross margins.

Can you expect follow-on of higher gross margin products to come? Is there anything unique about that, or what's the timeline and tempo of when that pull-through will happen, or will there be additional layers of some more wins that we should think about? I just want to see. It seems quite like a positive more than a negative. Thank you..

It is a positive, Jim. And I think that each one will have kind of a different cadence, and you're right. The initial footprint has lower margin than the average deal will achieve. We typically achieve kind of average deal in the two to three-year kind of timeframe. The one that I talked about in Asia, it's going out with Instant Bandwidth.

So the first thing they will do is deploy. They'll turn up the circuits with I think a couple hundred gig, and then that leaves them still several hundred gig that they can get with Instant Bandwidth.

What I typically have found is that the ramp of the Instant Bandwidth after a large deployment typically starts three to five quarters later, and then you start seeing steady growth of increased capacity. Every customer is different, but that's the average..

Jim, I would reinforce Tom's comment. This is absolutely a positive. The way that we're winning, the types of customers we're winning, the amount of unlicensed bandwidth that we're deploying is a great situation for us and for our shareholders..

Thank you so much for the details and clarifications and congratulations..

Thanks Jim..

Thanks..

Our next question comes from Simon Leopold of Raymond James. Please go ahead..

Great, thanks for taking my question. I just wanted to first get a housekeeping one out of the way. I don't think you made a comment on 10% customers.

Would it be possible to get a little bit more color on the top customer contributions?.

Sure, two greater than 10%, one being the large cable customer, the other being the recently combined Tier 1 in the U.S..

Great.

And combined, how big were they?.

Combined....

About 35%..

Yeah..

Great. (51:06).

Simon, take a look at the CFO Commentary for a little more on that..

Yeah..

Okay, I appreciate that. So, Tom, earlier, in answering another question, I think you made a good point about the quarterly movement of gross margin, and I appreciate we shouldn't focus on one quarter because you clearly had some new projects activity slide into 3Q, so better 2Q.

So what I think we're all trying to get at is, what should we think of as a normalized gross margin? And ideally, I'd love to get your views on what it should look like in 2019. That would be great, but some way to think about what is the normalized level. Thank you..

I think I'm going to answer, and then I'm going to ask Brad to point specifically. 2019 becomes tricky because we'll be a consolidated company with Coriant. Their margin at a product level, until we can fix some cost structure items, will certainly be dilutive to our gross margin profile.

We anticipate that will take a couple years to get back into the 40s. For Infinera standalone, I think we had anticipated that our gross margin would be in the mid-40s by early next year.

And I would say that based upon the wins we're having, the cost structure of ICE4 actually hitting or exceeding actually our internal targets, I would say that we're on track for accomplishing that.

But from a consolidated point of view, we will have probably more data for you at our Investor Day in Q4 to give you the specifics of how that will all blend out. As a combined company, we're still remaining committed to our long-term gross margin model of 50 points, but that's including our ICE infrastructure into the major Coriant platforms..

Simon, when you say normalized, it's hard to get to a normal. But I would say, once we get past the initial phase of winning these new customers, we'll continue to win new customers, but you will have follow-on growth in terms of additional capacity that puts you somewhere in the low to mid-40s next year as a standalone.

Tom is right that it will change after the deal, but that at least gives you a feel for that on a standalone basis..

That's very helpful. Thank you for taking the questions..

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

Excuse me. Hello, good afternoon, and apologies if I'm repeating anything here, but I wanted to ask about I guess carrier cloud, in general, customer reaction to the Infinera-Coriant merger since the announcement of the deal, if you have anything anecdotally to share, and maybe you mentioned something earlier in the call that I missed.

I was intrigued by your comments around footprints at Level 3 CenturyLink coming out of the Coriant deal, and that obviously could be useful. I wonder if you have anything else to share along those lines of what you've been hearing from customers since the announcement..

The overall customer response has been very, very positive, and it's been certainly positive by the long-term Tier 1s that Coriant has been servicing. It's also, I would say, positive from the ICPs that we've talked to, positive or neutral, it's one or the other. Some people haven't been looking at them and they don't really care.

Some people are looking at them and actually buying from them, ones that we didn't have, and they're actually – at first they were pensive about what's your plan, and we told them that we're going to continue with the product offering. And then they were delighted. They really enjoy the Groove platform.

It's got a very nice architecture with the sleds that they innovated around, and they have got some good traction with some ICPs that we did not have. I think it opened up, as we talked about in my commentary, Tier 1 and ICP customers.

Both of them I think are important in this acquisition and they introduce us to customers in both of those markets that are substantive and meaningful for our long-term success. So we've had zero negative commentary.

A couple of people on the ICPs were neutral because they don't use them and don't care, and some are actually very happy because we've told them that we will continue with that Groove platform. And they are going to continue, to the best I know.

At least they articulated they will continue with their deployment activities, which are actually just starting. So I'm actually optimistic..

Thank you..

The good news is everybody wants us to come in once the deal closes and give them an update on the roadmap. The first thing you tell them is we're not killing it. Great, tell me what you are doing.

And we have to say, well, until the deal is closed, we are restricted on what we can offer and we are restricted on actually even dealing with Coriant on what plans are. But I can tell you, the last thing we're going to go do is disrupt revenue streams from customers that we want to go and have as part of our portfolio..

I would add a little bit of color from a financial perspective. Obviously, I've gotten several requests to meet on the financial side because they see it as a very big positive that them being under our ownership is a much more stable situation for them. They don't have to worry about going forward.

So I think customers are also looking at it as a big stability point under our roof..

Thank you..

Thanks Tim..

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

Hey. Thanks, guys. I just wanted to turn quickly to the R&D line item and that you had mentioned that it would take a step down in Q3 with the completion of the portfolio.

And I just wanted to dig in there because I know a couple of years ago the idea was to step up R&D to have a faster cadence, and so I would have thought that resources would just be moving to the next generation.

And so is there just a higher portion of fixed sampling costs that we don't see? Is it anticipatory moves ahead of Coriant, or is there just less overlap there?.

So, Meta, if you go back to our commentary around the restructuring we did, we actually cut deeper than we publicly talked about and we actually shifted dollars to the PIC and module side of the business to continue to allow us to be on that faster cadence train.

The underlying R&D for the remainder of it, there's always – when you do an entire refresh of an entire portfolio, there is a lot of cost around protos, this type of stuff, that once you finish that refresh you're going to continue to work on new products but it's not going to be a full refresh of the portfolio.

That's what allows us to start to drive down..

And if I can add in there, some of that reduction in R&D, going forward, is just the fact that we aren't making the same level of prototypes that we had in the past because of the released products. So these aren't people drops, these are just a prototypes that we have to build in our engineering organization..

Got it. Thanks. And just as we think about I think in the past like the industry size, kind of DSP development at around $50 million to $75 million a generation. Like what do you guys size as the approximate for kind of each generation of PIC..

I think first I'd calibrate the DSP development as less than what you've got there, it's still significant. But I would scale that more in the $40 million type range instead of $50 million to $70 million for the DSP. The optics for each generation, I would probably put it in the $20 million type of range. Those generations sometimes span each other.

It's not one big bang event always..

Great. Okay, that's helpful. Thanks, guys..

Thanks Meta..

Thanks..

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

I just want to thank you all for joining us this afternoon and for your questions. We look forward to updating you on our continued progress, and we'll see you at the Analyst Day. Have a great day..

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