Infinera Corporation
Q1 2016 Earnings Call Transcript

Published: 28 Apr 2016

[Operator:]

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

[Jeff Hustis:]

Thank you, operator. Welcome to Infinera's first quarter of fiscal year 2016 conference call. A copy of today's earnings is available on the Investor Relations section of Infinera's website. Additionally, this call is being recorded and will be available for replay from the website. Today's call will include projections and estimates that constitute forward-looking statements. These may include statements regarding Infinera's overall business strategy, market conditions, market and growth opportunities, Infinera's results of operations, views on Infinera's customers and its products, integration of Transmode as well as Infinera's financial outlook for the second quarter of fiscal 2016. These statements are subject to risks and uncertainties that could cause Infinera's results to differ materially from management's current expectations. Please refer to Infinera's current press releases and SEC filings, including Infinera's most recently filed quarterly report on Form 10-Q and subsequent filings for more information on these risks and uncertainties. Please be reminded that all statements are made as of today and Infinera undertakes no obligation to update or revise any forward-looking statements to reflect events or circumstances that may arise after the date of this call. Today's earnings release and conference call include certain non-GAAP financial measures. Pursuant to Regulation G, Infinera has provided a reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures in its first quarter earnings release, which has been furnished to the SEC on Form 8-K and is available on Infinera's website in the Investor Relations section. I would now like to turn the call over to Chief Executive Officer, Tom Fallon.

[Thomas J. Fallon:]

Good afternoon and thank you for joining us on our first quarter 2016 conference call. Joining me today are Chief Financial Officer Brad Feller, and President Dave Welch. Today I'll go over financial highlights for Q1 and provide an update on our business and (02

[Brad D. Feller:]

Thanks, Tom, and good afternoon, everyone. As Tom mentioned, we had a solid Q1 delivering revenue that exceeded Q1 historic industry trends and was in line with the midpoint of our guidance range as we executed on opportunities across our product portfolio. I was very pleased that we expanded our best-in-class gross margins to 50% in the first quarter. Q1 revenue was $245 million, a 31% increase over the first quarter of last year and down 6% sequentially. Our business continued to be diverse as our top five customers in Q1 were comprised of two cable operators, a Tier 1, a wholesale and enterprise carrier, and an ICP. Three of these customers were greater than 10% of revenue in the quarter

[Thomas J. Fallon:]

In light of our Q2 guidance, I'd like to share some final perspectives. We're coming off a remarkable succession of quarters where our results and guidance exceeded the investment community's expectations. While we are disappointed in our Q2 outlook, we are also cognizant that our industry can be lumpy from quarter to quarter. This being said, I encourage you not to allow the short-term fluctuations to blur your perspective of Infinera's tremendous long-term opportunity. We believe bandwidth demand will continue to remain incredibly strong driven by megatrends that will last for several years. In addition to the ongoing migration of workloads to the cloud, we also see video as a key bandwidth driver as Facebook delivers video autoplay and Twitter announced their intent to stream NFL games. These types of services demonstrate the increasing importance of delivering high-quality video content towards ICPs. ICPs are also seeing a bandwidth multiplication effect as their architectures increasingly distribute applications and replicate data, driving server-to-server traffic to grow even faster than server-to-user traffic. Finally, we see network evolutions like the rise of gigabit cities, the Internet of things, and 5G mobile, all having multiplier effects on bandwidth demand as well. We see these developments as guidepost of the broader industry's health as customers will increasingly value Intelligent Transport Networks as the optimal way to respond to this massive demand growth. Our next-generation technologies are ideally suited and well-timed to address the emerging network requirements and will play an integral role in enabling us to continue to deliver highly scalable cost-efficient networks and the best customer experience in the industry. I am exceedingly optimistic about Infinera's opportunity. By continuing to execute, we expect to gain market share across the end-to-end optical transport market and to deliver outstanding bottom-line results while doing so. Now, I'd like to turn the call over to the operator to begin the Q&A portion of the call.

[Operator:]

Thank you. Your first question comes from the line of George Notter with Jefferies. Please go ahead.

[George C. Notter:]

Hey, thanks a lot, guys. I guess I wanted to sort of dig in on this discussion of lumpiness that you're seeing in the business right now. Can you tell us anymore in terms of what exactly you're looking at? How many customers are we talking about here? Is this a reflection of any kind of product development issues or overhang ahead of the pending availability of the 2.4-terabit capability? Sorry for all the questions here. But...

[Thomas J. Fallon:]

That's okay, George. You want some understanding. I got it.

[George C. Notter:]

Yeah. I mean, is this related to certain products, long-haul, metro, Cloud Xpress? Is it related to certain customer types? I mean, any more you can kind of give us would be great.

[Thomas J. Fallon:]

So I'll walk you through probably more detail than I usually give because it is an interesting time. The overall environment, as I said on the call, I still see a huge amount of bandwidth demand. So I don't think that there's anything fundamental in the industry that's causing a problem. I also think when I look at the business environment, it's neither great nor bad. It's kind of an okay environment. We see customers deploying. We don't see any kind of freeze on things. But there have been a couple of areas that are stronger and some weaker than others. So on a strong perspective, Q1 bookings, for instance, in the long-haul market was the best bookings quarter we've had in a couple of years. For the CX product, we had record revenue and bookings in Q1. Both of those spaces did very well. In the metro market, I would call this – we've had a mixed kind of quarter. We picked up new customers as you've seen. We announced today a really significant cross-selling opportunity. We've announced two of the three wireless front-haul architectural wins that we announced. We picked up several new smaller customers. But we have one significant metro customer who has historically been part of the Transmode customer base and who hasn't bought for about two quarters. And there's nothing, I don't believe, that's structural there around the relationship. We believe that there is a big opportunity for us in the next quarter or so. There's an opportunity that's been driven to them by one of their customers, and I think they get back on track soon. Having said that, it's a big enough customer that it's really tough to backfill that in the short term. North America was pretty strong in general. I continue to see it being strong. Europe was reasonable. LatAm and APAC were a little bit softer than usual and a little bit softer than we had anticipated, though I don't think it's anything more than timing. So that's kind of where the overall business looks. I think overall, like I said, a pretty healthy. One of the things that rattles around in my concern list is we've seen over the last couple of weeks Ericsson had a pretty concerning, I guess, result. Juniper's pre-announced. Both Microsoft and I guess Google kind of missed expectations. And I have a little bit of pensiveness around me until I see more results of what's happening in the broader market. As I talk to the suppliers who sell us optical components, they're kind of calling it an okay environment too, except for China which is extraordinarily strong. So I think China continues to drive a huge amount of component demand, and they're seeing the rest of the world just be okay, which is kind of where I see the world as being okay. We talk to industry analysts. They're still forecasting the overall (29

[George C. Notter:]

Got it. So, that's super helpful. One quick follow-up. So if I were to parse the delta relative to, I guess, pre-expectations for June, is it fair to say that most of the difference comes from this particular customer on the Transmode side or is that just one smaller component?

[Thomas J. Fallon:]

I'd say most, but not all. There are other things that are less dramatic as a percentage basis, but that's, I would say on a percentage basis, the most significant one.

[George C. Notter:]

Okay. Thank you.

[Operator:]

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

[Alex Henderson:]

Thanks. I think that was very helpful discussion, but could you parse a little bit between the product and the installation services side of it? This variance in the quarter for us was on service, and so are we going to see a continuation of that? In other words, a fairly slow service and a little bit more skew to product in the quarter as you fill line cards and the like?

[Brad D. Feller:]

Yeah. So, Alex, Q1 is normally a softer quarter for us for services because the deployment services tend to be smaller in Q1 because it just takes time for customers to finalize their budgets, purchase it, get it installed. So a lot of that revenue carries over and doesn't get recognized in Q1. So that's just more of a Q1 dynamic. Obviously, if we talked about two other dynamics within services, one, as the installed base grows, the services revenues grow. But we are in a phase that it's more capacity adds versus new networks. So those two things will counteract each other a bit.

[Alex Henderson:]

So the guidance for the June quarter is more biased to product than normal and the seasonal swing in service is probably less – is more dampened than normal?

[Brad D. Feller:]

Yeah, I mean it's obviously services 10% to 15% of our revenues. So it's more of our product issue than it is a services issue that we're seeing from the revenue side of things.

[Alex Henderson:]

Okay. Thank you.

[Brad D. Feller:]

Thanks.

[Operator:]

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

[Vijay K. Bhagavath:]

Yeah. Hey, thanks. Hey, Tom, hi, Brad.

[Thomas J. Fallon:]

Hi, Vijay.

[Vijay K. Bhagavath:]

Hi. So it's a solid execution in Q1. It's been a rough start of the year for many of your peers. So congratulations on the better-than-fair Q1. A question for you and a follow-up if I may. The question is on Transmode starting to hit the U.S. market, your U.S. customers. Help us understand the Transmode dynamics in the U.S. Do you have a design win pipeline already in place with some of the major cable companies, et cetera? And would the third quarter be earliest in terms of getting revenues from these U.S. customers for Transmode? Thanks.

[Thomas J. Fallon:]

So we certainly have a pipeline of opportunities that we're developing with North America customers. The Telia announcement we made today is actually for their North America network. Telia's been a long-term Infinera partner. I believe we have 100% of their international North America backbone and now we're going to move into their metro. And it's interesting because, obviously, Telia is headquartered in Stockholm, which is where Transmode is headquartered. But they were unable to craft a deal until we acquired them. And because of our great relationship with Telia we've now become an end-to-end supplier in the North American network. It's one of our – it's not our first cross-sell opportunity, but it's one of our more important ones because it demonstrates we're dealing with a Tier 1 international carrier, that they value this end-to-end performance, they value the Infinera relationship, and they have confidence in us delivering that Infinera experience to them. We continue to do a reasonable amount of growth in North America, and I believe in the metro for the Transmode product, most of the growth will come out of North America. We are investing heavily and as you know we have a significant portion of our customers and our revenue come from North America historically. And I view a number of these as being potential TM-Series extensions of DTN-X networks. We're in different phases of trial, some with cable, some with wholesaler, some with – I can't remember if there's other markets we're those other markets enterprise through channels. So there's a number of deals that we're working on with our current customers to see if they will pick them. I think that, as I said, these take a long time because you have to not only find the right opportunity; you have to convince them that you are a compelling value proposition, and you've got to convince them to displace somebody that's already there. So it doesn't happen overnight. I still believe we'll have a better sign or a better understanding of the opportunity in the second half of this year and that's where I think these cross-selling opportunities will start kicking in. But I do believe North America represents our best avenue for growth for that product offering.

[Vijay K. Bhagavath:]

Then a quick follow-up, Tom, is just a bigger picture question, that a landmark moment for the company would be starting to sell into the major U.S. telcos such as Verizon, AT&T. You think your entry point into Verizon or in AT&T would be the metro product or would it be like the data center optical product? Thanks.

[Thomas J. Fallon:]

Well, we – no, we constantly are working to sell to those guys. I think there's a number of potential opportunities. There's wireless fronthaul opportunities with our Transmode product. I mentioned that we've run three, and we're actually in trials or labs with another half a dozen or so. I'm not going to mention which ones they are, but they're significant carriers. I think that cable represents – I mean, sorry, CX represents opportunities potentially for the carriers, AT&T and Verizon. And quite frankly, there's interest in our solution around SDN. So we're going to continue to work very hard to earn their business. Having said all that, I just want to remind people my view. We're building a great business with or without the AT&Ts and Verizons. I think we can continue to grow this business faster than the market because the people who are investing the most in network are the Internet content guys, the cable guys, and the wholesale and enterprise carriers and that's our – we are best positioned. I want the business. I want to earn the business. It will help us grow. We don't need it to grow.

[Vijay K. Bhagavath:]

Okay. Thanks, Tom. Very helpful.

[Thomas J. Fallon:]

Thanks, Vijay.

[Operator:]

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

[Simon M. Leopold:]

Great. Thank you for taking my question. So, I wanted to first see if I could clarify the sort of sources of weakness in terms of your commentary. It sounds like you're pointing to sort of two aspects. One is lumpiness in long-haul, but somewhat softer metro. And I want to get a better understanding of that softness in metro. How much of that is sort of Transmode-related and how much of that is traction on the new XTC platform? And then in terms of kind of the longer-term trend, your exposure to ISPs' web-scale. I believe in the past you've talked about that as being 20%, 25% of revenue. I want to make sure I've got that number right. And if you could talk to how you expect that trend evolves over the course of the next, let's say, one to two years, thank you.

[Thomas J. Fallon:]

Yeah. So, two questions. I'm going to take the first part on is it the TM-Series from Transmode of the XTC-2 family that we introduced. And they're two different things. So the TM, I think the softness that I talked about specifically with that one significant customer is a TM issue. And the challenge is that as we're trying to win these and are winning cross-sell opportunities, it's too big of a hole to fill in the very, very short term. So, I think the TM Series product with that one customer is most of that issue. The XTC-2 is actually being well received into the market. We've won some opportunities. We're being trialed in other places. But it's a relatively long sales cycle, and I anticipate that it'll take a few quarters to start generating meaningful revenue. So I can't backfill – we can't backfill that hole with XTC-2 right away. Whether the XTC-2 is going to see a weakness in the market, which is might you'd (39

[Brad D. Feller:]

Yes. So, Simon, we've said historically that each of our individual verticals are 20% to 25%. The growth in both Internet content providers and the enterprise and wholesale carriers has grown faster than the overall market. And obviously, the wholesale and enterprise carriers carry a lot of that traffic for the ICPs. So those two verticals combined is more like half of our revenues today.

[Simon M. Leopold:]

And how is that changing over the next one to two years?

[Brad D. Feller:]

Yeah. I mean I think those guys are going to continue to grow at a very fast clip. We see the ICPs defining the next-generation architectures, they're building very aggressively with cloud, that kind of stuff. So my expectation is they will continue to be a very healthy chunk of the overall revenues.

[Thomas J. Fallon:]

Yeah, I think it's going to be very healthy. Whether they're going to be growing as a percentage or not, uncertain, because I anticipate we're going to go and be more successful going into metro markets, enterprise markets, those types of things. So I think that they will be an important part. They're going to continue to grow a lot. Whether their percentage grows or not, I actually hope not because I think that we need to grow the rest of our business even more.

[Simon M. Leopold:]

Great. Thank you for taking my questions.

[Thomas J. Fallon:]

You're welcome, Simon.

[Operator:]

The next question comes from Sanjiv Wadhwani with Stifel. Please go ahead.

[Sanjiv Wadhwani:]

Hey, thanks. Couple of questions. Tom, on the large customer on the Transmode side, what gives you the confidence that it is going to come back? It looks like you're saying it's probably going to come back in the next quarter or two quarters, I guess. Is there a new build over there or something else going on that gives you that visibility? And then one quick question for Brad. In terms of the gross margin strength in Q1, you talked about a mix being sort of different in Q1 that impacted gross margins positively. Can you just give a little more detail on that? Thanks.

[Thomas J. Fallon:]

Yes. So, why do I have confidence in it coming back? It's been a long-term customer that had a very good relationship previously with Transmode and with us. We've talked to them about their business and why it has slowed down, and there's a specific opportunity that they've won or are close to winning that when that happens their intention is to reinstigate significant purchases with us. Until it's done, it's not done, but I have every belief that what they're telling me is true. I have no reason not to believe it. And then timing becomes a question. Is it a Q2 or a Q3? We're obviously not counting on it being in Q2.

[Brad D. Feller:]

So, Sanjiv, to touch on your gross margin question, it's a combo of things. One, obviously, the deployment services being less, as those are less than corporate average margin, that pushes up the services margin and the overall margins. Also, Q1 being more capacity adds, those capacity adds tend to deliver much higher margin profile for us. And we've said that our margins ongoing will be steady in that 47%, 48% range, but that it could move a point or two either way, based on the mix of the business.

[Sanjiv Wadhwani:]

Got it. That's helpful. Thanks.

[Thomas J. Fallon:]

Okay.

[Operator:]

Next question is from Doug Clark with Goldman Sachs. Please go ahead.

[Douglas Clark:]

Hi. Thanks for taking my question. It was interesting that you didn't call out cloud or Internet content providers for the second quarter guidance. I'm wondering on your expectations for the second quarter, if indeed you expect that to grow off of a record first quarter. And then similarly and related, are you seeing any change in the competitive dynamic? A few of the large competitors are now a little bit more pronounced in the market, so I'm wondering if that's factoring into purchasing decisions as well.

[Thomas J. Fallon:]

Well, I'll take part of it, and then I'll let Brad and Dave answer part. I don't think in our guidance we've ever called out any kind of guidance in the future except here's our revenue, here's our margin, here is our earnings. So we don't do anything around any specific market when we're giving our guidance. So please don't read this as unusual. I believe we're going to have – in regard to ICP market, we sell a lot of different product into that market. We sell DTN-Xs; we sell CXs. I assume you're talking about the CX, and I anticipate another strong quarter on CX. Whether it will be a record quarter, I don't know. But it's going to be a strong quarter on the back of a record quarter, and it's going to be from a couple of new customers that we've just won and haven't been announced yet, and it will be mostly driven by the same people who have driven this growth over the last couple of quarters. So I'm still very positive on the cloud market and our position in that cloud market from a growth of customers and pervasiveness within the customers we've won. Dave, you want to comment at all on new competition we're seeing in that market?

[David F. Welch:]

Sure. This is Dave Welch. There are products that are slowly coming online. To address this, for the most part we aren't seeing that as having any major impact on our market share for that. They are comfortable with our deployment processes, our capacities, our densities of our current CX products and they've shown tremendous excitement about our future-generation CX products.

[Douglas Clark:]

All right. Thanks for that. And then my follow-up question was on the Infinite Capacity Engine. I know you talked about a timeframe of later this year in terms of product introduction. Can you give us a little bit more specificity in terms of what the timeline for seeing product in market could be?

[Thomas J. Fallon:]

No, we're going to go and announce – we're going to have Infinera – Insight Infinera in Q3, and we're just going to have to make people wait.

[Douglas Clark:]

Got it. Thanks.

[Operator:]

The next question is from Stanley Kovler with Citi Research. Please go ahead.

[Stanley Kovler:]

Thanks. I just wanted to ask if we can get some clarification on any FX impact around Transmode as well. And if I think about Transmode sequentially and then into Q2, can you help us understand the operating level of revenue that Transmode is on versus when you bought the company? I was thinking like it's somewhere between $150 million, maybe, and $180 million in revenue that they were on track for – approximately heading into 2016 and how that compares to where you see them now. And I know that you haven't explicitly given your guidance but just curious on that. And then separately, on the product cycles outside of the European customer, can you help us understand how the products from September are tracking versus your prior product cycles with DTN-X and how it compares at this stage of the game along that adoption curve? I have a follow-up. Thank you.

[Brad D. Feller:]

Okay. Stan, I'll try to address each of the components you brought up. First, on FX, like any company, the devaluation of the euro over the last year for customers that we have things denominated in euros obviously hurts us. But it's something that we factor into our guidance, that we put hedging in place where we can, and like anyone, like I said, it impacts us but it's not a huge driver in the overall results. But it is a headwind for us. In terms of your question on the Transmode side of things, we're not, as we said before, going to break out that business separately. But I just want to clarify one thing. You said $150 million to $180 million run rate. They were more on a $120 million to $130 million run rate if you looked at last year. And we continue to be happy with what that business is doing. Obviously, as we continue to get cross-sell opportunities, we'll be able to expand that business, and longer-term put our vertically integrated technology into those products. In terms of your question on the product cycles, as Tom mentioned, we've seen good traction on some of the new products, whether it's the Transmode gear, whether it's XTC-2, whether it's XT. Inevitably, though, those things, from a, they're interested, they've given us a design win, to actually significant revenues, it takes time. I wouldn't say it's any different than past cycles per se. I would say it's fairly normal.

[Thomas J. Fallon:]

Yeah. It's certainly different than when we originally launched the DTN-X because the DTN-X was a step function of capacity improvement replacing basically the DTN, and a vast majority of our customers who had DTN migrated very quickly to DTN-X. So it was a market that we already had a very dominant position in and it was our next generation in that same market. These new platforms are taking us into new markets where we're having to typically replace an incumbent that's not us. So it's going to be slower than certainly the DTN-X ramp, but as Brad said, we're comfortable with the trajectory that we're on. And I think by later this year we should have some – we'll meaningfully know if it's going to impact revenue in a positive way.

[Stanley Kovler:]

Thanks. And just to follow up, outside of the European issue, how are we thinking about the seasonality of CapEx for this year? I mean, obviously, it seems like first half of the year is turning up to be a lot weaker than prior years; in terms of seasonal patterns, more back-end loaded. Are you thinking about giving more of a full-year outlook? And besides that, how are the carrier decisions around NFV and SDN and these changing architectures factoring into the push-out of their decisions on new products? Thank you.

[Thomas J. Fallon:]

So I'm going to take part of this first. You've said a couple of times that the European customer we mentioned – you're drawing a conclusion that we mentioned a European customer. We said, a customer, and I would encourage you not to geographically assume. In regard to CapEx spending, like I said, I'm seeing an okay environment in general. I'm not seeing anybody saying we're scared to spend, or our corporate's coming down and saying there'll be no expansions. I'm not seeing people throw caution to the wind and a build-it-and-they-will-come model either. I'm seeing pretty rational behavior in spend, and what I continue to believe is that what's going to continue to drive the expenditure is just raw bandwidth requirements. There is nobody telling me – I mean nobody – that they're not seeing a continued growth in bandwidth. And as long as there's a continued growth in bandwidth I feel very comfortable we're going to continue to grow the business. And that will trump FX issues, it will trump a problem here or a problem there with a customer. And I am as bullish as I've ever been on the bandwidth environment in the medium- and long-term. It is very fundamental, the things that are happening. In regard to NFV and SDN, I think we see more and more requests for SDN and NFV, particularly for us SDN, to be presented to them our solutions. And I think we do a fairly good job of articulating a very cogent strategy and the value proposition of both our SDN solution, but more importantly the underlying hardware of our intelligent optical network. And I think we – this summer you'll see us make some more announcements, and in August you'll hear a whole review of it. And I think, actually, SDN positions us very well to sell more optical gear. I think I've said this before, and I mean it. Our architecture was built to be SDN-ready. It's not because we saw SDN but we saw what an intelligent optical network can do. And I do believe that the more pervasive SDN becomes the more applicable Infinera's architecture is within that. Unlike the router guys or the switch guys, our stuff's not going to be subject to NFV. People aren't going to virtualize what we do. A photon going from A to B takes what we do, and no software's going to replace that. All of these things to me are exciting because it makes the optical layer more strategic. Having a giant pool, an infinite pool of intelligent bandwidth is what enables SDN and NFV to come to life. If you have constrained optical capacity, you can't have a responsive, adaptive network. We have the most unconstrained optical capacity, scale of capacity, because of our PIC design. It pumps me up.

[Operator:]

Thank you. The next question comes from Rod Hall with JPMorgan. Please go ahead.

[Rod B. Hall:]

Hi, guys. Thanks for giving me a question. I've got two, I guess, for you. I wanted to go back to the gross margins because you guys disclosed products and services gross margin at the GAAP level. And both of them moved up pretty healthily in the quarter, and so I just – yeah, I know, Brad, you made that comment about mix affecting the margins. But on an isolated view, are the products and services gross margin you guys are showing us here in Q1, how sustainable are those? And why should – if you're going to tell me they're not sustainable, why should we believe they do back off again? And then I've got a follow-up.

[Brad D. Feller:]

Yeah. The services side I think are sustainable because obviously, the more the follow-on maintenance services grows and the install base grows, that is obviously very high margin profile. Now, from quarter to quarter it can move around a bit based on how much deployment revenue we have, but over time, I think they will sustain at this level. The product side, as I said before, can move around a point or two from quarter to quarter. And obviously, we wouldn't be talking about an intermediate term of 50 points of gross margin if I didn't think we could do it on a consistent basis. We're just not there yet. We will have quarter where we would hit it, but it's going to take us a little bit more time to sustainably be there quarter-after-quarter. And it's really just largely mix-driven. And it could be reserves in the quarter; it could be warranty cost. There's a lot of things that are involved with margin. They move things around point or two in a quarter.

[Rod B. Hall:]

Okay. And then – yes, thanks for that. And then my follow-up was, Tom, in your opening comments, you talked about this misperception of long-haul. And I think a lot of people see long-haul as either on or off, it's 100 gigabit or it isn't, and of course there were a lot of (54

[David F. Welch:]

Yeah. This is Dave Welch. I think I'm going to break your question into two questions there. The pertinent questions are what fraction of new bandwidth going in the ground is 100 gigabit versus 10 gigabit. And the answer is the majority of long-haul traffic bandwidth going underground right now is 100 gigabit. That is – the second important question is how much is that traffic and continue to grow. And the growth vehicles that drive this are substantial and are multiyear in there. You've got more and more services. Tom mentioned video services, cloud video services, and then you've got 5G migration on top of that. So you've got an underlying pressure where you've got access to the individual via the move into 5G that is going to drive substantial access bandwidths up. And then you have – that hits a data center multiplier on top of that that is going to drive a lot of that traffic out over to long-haul. The old networks had kind of a rough 80%/20% rule. The voice network had an 80%/20% rule where 80% was local and 20% was long-haul. Now that the long-haul has allowed large content of data-center-to-data-center interconnect traffic that no longer holds. And much more of the total bandwidth traffic will be in the long-haul sector as opposed to isolated in a metro access sector.

[Rod B. Hall:]

But Dave, do you have any idea how many wavelengths out there are 100 gigabit-stage versus other speeds? I mean I would think it's a pretty low number but I'm just curious if you ever seen any quantification of that.

[David F. Welch:]

Total bandwidth deployed in 100 gigabit is greater than total bandwidth at 10 gigabit right now.

[Thomas J. Fallon:]

Yeah, that's 80% of the 100 gigabit. It's not the number of waves, but it's 80% of the capacity, I think, is at 100 gigabit today.

[Rod B. Hall:]

Okay. All right. Thanks, guys.

[David F. Welch:]

Thanks.

[Operator:]

The next question comes from Jess Lubert with Wells Fargo Securities. Please go ahead.

[Jess Lubert:]

Hey, guys. I also have two questions. First, for Tom, I was hoping to understand given some of the choppiness you're seeing to what extent there's been any change in your market growth expectations for the year across the different verticals, and to what extent you do expect the business to strengthen or return to normal seasonality as you look out towards the second half of the year? And then for Brad, I was hoping you could help us understand how you're thinking about the need to invest moving forward and to what extent you might continue to invest ahead of sales if the business remains sluggish beyond the June quarter?

[Thomas J. Fallon:]

Yeah. So, what we've been clear on is our expectation has been that we will grow faster than the market. That's not very useful because we are really in the long-haul market now, the metro market, and the cloud market. And my anticipation is that we need to grow faster than the market certainly in long-haul and faster than the market certainly in metro. The long-haul market is supposed to grow 7% to 8% for this year and we will certainly stay to our commitment that we're going to go faster than that. The challenge is we've probably grown three times the market rate the last few years. I had no anticipation of growing three times or even double the market rate this year in long-haul because if you look at our market share in long-haul, certainly in North America, we're going to have a hard time growing much faster than the market. We have just too large of a market share. So we have to continue to expand outside the market. So you should assume in the long-haul we anticipate beating the 7% to 8%. In the metro market, it's forecast to grow roughly the 8% to 9% range. We're obviously a relatively new entrants in that with the opportunity to cross-sell a lot of TM-Series platform, which I believe we can go do; and then the introduction of the XTC-2 family. So we should be able to go certainly faster than the metro in that space. The one caveat being it's a lot of new products for us to introduce and that takes a bit of an adoption cycle. In the cloud market – the CX market, that growth is all over the map of what industry analysts expect. And I think we're going to continue to grow rapidly there, but I don't have a good sense for what – really how fast the market will grow. And we're going to be challenged there. If you look at the what is called the pure play, dedicated, purpose built cloud box, we had 100% of the market last year because we basically created the market with the CX. So we're not going to maintain a 100% market share. There will be competitors who have introduced some products – some of them look pretty good – that will win some market share. I do believe that we can grow certainly more than double-digit growth in that market this year without question. The question really becomes, to me, how fast will that market grow. And it's really hard to get an understanding of that. We get better, probably, data from our customers than we get from industry analysts. So I'm anticipating that will continue to grow at a good clip.

[Brad D. Feller:]

So just to address your question on OpEx and investment. We've talked about for a while that 2016 is going to be a year where we need to invest. We are going away from just being a long-haul company that's attacking $5 billion market and now addressing markets that are expected to be $12 billion to $15 billion over the next several years. It's critical that we get out the next-generation technologies. So as I mentioned, we'll stick to the 20% of revenue in R&D to make sure we get the next-generation technologies out. We continue to invest in the sales side of things to make sure we got the right resources to attract the broader markets. That being said, we will look at certain spend to make sure that we're spending on the most important things and put some restrictions. But let me be clear, we will continue to invest.

[Thomas J. Fallon:]

We will continue to invest but, I'll be also clear, we're not going to invest with the expectation of making that increased revenue. We're kind of a pay-as-you-grow kind of company. We'll continue to invest in R&D because I firmly believe in the opportunity ahead of us across the next several years. I believe we have a lot of opportunity to grow our revenue with our current investment in sales. We're going to hire selectively. But I think we will look carefully about expanding G&A and those types of things.

[Jess Lubert:]

Is it feasible to think that operating margins in the second half to be flat relative to the first half?

[Brad D. Feller:]

It depends. We're not going to go that far out.

[Jess Lubert:]

Thanks, guys.

[Thomas J. Fallon:]

Okay. Thanks.

[Operator:]

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

[Thomas J. Fallon:]

Hello, Tim. How are you?

[Tim Savageaux:]

I'm doing all right. Thanks. Good afternoon. Clarification on the previous discussion about, I guess, the Transmode customer issue with regard to its impact, whether that's commentary about Q1 just reported or Q2 anticipated. And I guess my confusion tends to be some degree from, you had a very, very sharp drop-off in Latin America. And so, I guess, is that – and yet we're still able to put up some pretty good numbers for the quarter. So is there a relationship there? And is that – I guess is that looking backward or looking forward commentary with regard to Transmode customer issue? And then I've got a quick follow-up.

[Thomas J. Fallon:]

Yeah. It's not a LatAm issue at all from a metro perspective. LatAm – Brad can comment on LatAm in general. We're seeing lot of opportunity in LatAm. I would say it's more seasonality in LatAm than anything else. In regard to the TM customer, whether it's a backward looking or forward-looking, the answer is yes, it's backward-looking for Q1 and it's forward-looking to Q2, so both.

[Brad D. Feller:]

So Tim, it's one of those things where they've slowed down spend. We still think it's a healthy customer and will be a good customer over time. They've just significantly slowed down their spend. We don't think it's a competitive issue. It's just a timing thing. LatAm, Q1 is always going to be a lighter for us both in LatAm and APAC, just because it's a decent amount of it is subsea, which, as I commented on before, to be able to turn on those networks in Q1 tends to be more difficult. And it's a little bit just timing of customer spend. I expect LatAm and APAC to recover for the most part going forward.

[Tim Savageaux:]

Okay. And then just sort of follow up quickly on that, so – and assuming, as I would, that it's a relatively small amount of Transmode's revenues coming in the door for U.S.-based – I know you're trying to grow there. But assuming that's relatively small, you mentioned a pretty strong U.S. number. I think if you make some assumptions, you're talking about 30% type year-over-year growth, and overall kind of mid-teens organic growth for Infinera. As you look at either one of those metrics, U.S. or organic revenue, would you expect those are – it might – are those growth rates for Q1, I think, in the ballpark? And would you expect, I guess, to continue double-digit revenue growth for Infinera on inorganic basis, as would seem to be implied here based on how you can see your trends (01

[Brad D. Feller:]

Yes. So, we'll probably not going to get as exact as you would like us to get, Tim, but the growth year-over-year obviously is – Q1 last year we didn't have any Transmode. Transmode's existing business has been steady sans that big customer that Tom talked about, and not a lot of cross-sell synergies yet. So it's mid-teens growth for the Transmode business; it's mid-teens organic. And going forward, we'll see what the mix turns out with as we go forward.

[Tim Savageaux:]

Okay. Thanks guys.

[Thomas J. Fallon:]

Thank you.

[Operator:]

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

[Dmitry G. Netis:]

Thank you for squeezing me in, guys. I've got a couple of questions here, very quickly. On the Transmode, sorry to beat a dead horse here. but would I been incorrect also assuming this was historically the largest customer of Transmode that you saw weakness with? I mean can't we...

[Thomas J. Fallon:]

We're not going to go there (01

[Brad D. Feller:]

It was among the biggest. We can't go any more specific than that.

[David F. Welch:]

Yes.

[Dmitry G. Netis:]

And you made a specific comment that – I was just trying to see, was this not a European customer? Is it clear that it's not a European customer or (01

[Thomas J. Fallon:]

No, I once pointed out – somebody drew a conclusion that it was European. I didn't say it was European, and I wanted to make sure that other people didn't have me implying then that it was European. I'm just making a comment it was a large customer. So I'm going to leave it at that, Dmitri.

[Dmitry G. Netis:]

All right. Fine. Let's move on to a different topic then. The PAM-4 side, Tom, just to kind of get your perspective – I know you spent sometime in the script, and we appreciate that view. But to what extent or what percentage, I guess, of the DCI market do you think this technology can carve out? Have you given that some thought, that short reach PAM-4sof direct-detect technology? And then can you play in that market potentially? I know you – can you do a line cost (01

[Thomas J. Fallon:]

Well, I'm going to break it into a couple of parts, and then I'm going to Dave who's certainly more technologically savvy than I am to answer. I look at the PAM-4 opportunity in the short term as being an interesting architectural and marketing statement that has, I think, zero viable market share this year. So I think that it impacts our market this year zero percent. And I like what Andrew Schmitt has recently – he's the new – Cignal AI Consulting Group he started. And he's pretty astute engineer. And he estimates that the PAM-4 market will be about a $50 million to $100 million market by 2019. So by 2019 most people say that the cloud interconnect market will be a few billion-dollar market and this represents $100 million opportunity in that market. And he says PAM-4 is a short-termed tactical opportunity that will be marginalized as cost and power density of coherent improves. And I would agree with that. If you look at the history of capabilities that are semiconductor-driven, power and size improve over time. And I believe coherent will continue to be demonstrated the right solution. PAM-4 is not a solution today. It's a potential solution for later and the short-term opportunities may be a couple of years. So I think one of the things I like to say is I think it's a flash in the PAM is what I really believe about this technology. Dave, why don't you add some technology to that discussion?

[David F. Welch:]

Sure. I think this portion of the market that is successful via PAM-4, as Tom indicated, is something of shorter reach, and that I would tend to characterize that something as certainly on-campus type of architecture. And for an application, that is stuff going outside of the building to minimize the amount of traffic that will be able to be accessed by the PAM-4. So I don't see it displaying a – it will play a complementary architectural role to high-capacity coherent pipes. And further, coherent is going to continue to march down the path for very high-capacity lower-cost and lower power structures going forward.

[Dmitry G. Netis:]

And you guys don't have any intention of playing in that market potentially? As you said, it's potentially maybe just 5% of the total market by 2019.

[David F. Welch:]

So we don't have any intention in playing and whatever called the pluggable market of which PAM-4 is a participant in.

[Dmitry G. Netis:]

Okay. Great. And then....can I ask one more? Or....

[Unknown Speaker:]

Yeah.

[Unknown Speaker:]

Make it quick.

[Unknown Speaker:]

Make it quick.

[Dmitry G. Netis:]

Very quickly on the 2.4 terabit, and I think this question may have been asked by actually the first person on the call. But as you introduce the PIC, what was the response of your customers? And would you – or have you seen any posturing? I guess I'm looking at the downside of this, potentially, how customers come back to you saying, we'll wait for that product as opposed to buying the existing 500 gigabit product? Can you talk to that a little bit?

[David F. Welch:]

No, we're seeing customers continue to buy the bandwidth that they need. They're always looking to bring online as our customer and their applications required; there's no change in that. Remember most of our customers benefit from programs like 10 gigabit in 10 days or 100 gigabit in 10 days. And so the overhang is – minimal overhang of that at this point. They're excited about the operational simplicity that's added by going to deploying 2.4 terabits at a shot, very excited about how it integrates into our flexible optical infrastructure. So that – all things are going well in that front.

[Thomas J. Fallon:]

There's really not a worry in this architecture because our customers can take these new cards with the new PIC and slide them right into a DTN-X chassis. So this is not like they have to say, oh my God, do I have to buy a new chassis? You don't. Your investment-protected for this new technology.

[Operator:]

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

[Meta A. Marshall:]

Hi, thanks for taking my call. Just a quick question on whether you think that kind of getting the PIC into the TM-Series or into some of the Transmode series is critical to kind of expanding that base or kind of the cross-selling opportunity in your core customers.

[David F. Welch:]

I would say the cross-selling opportunities is really driven by customers that have an Infinera product now, that they like our operating system and they want to be able to roll that out to more and more applications. And for the most part, I'd say almost probably 75% or 80% of our DTN-X customers have an interest in doing that. That's driven by operational simplicity. It's driven by being able to turn services up on Infinera gear from end-to-end and the benefits that come from that. On top of that, the TM-Series becomes that much more stronger as we integrate our PIC technology on to their platform. It gives us a greater density advantages, it give us some interoperability advantages, it gives us some cost structure and power advantages as well. And they look at that, absolutely you see the upside.

[Meta A. Marshall:]

Okay. Great. And then just a quick follow-up on with some of your cable customers, I think some of them will change focus to DOCSIS spending later on in the year. And is that something that you will think will change spend on your products and there's kind of accelerating spend now or is it just unrelated kind of the pattern of spending on your products?

[Thomas J. Fallon:]

I think two things. Cable invariably spends most their money in the first half of the year, and we're seeing good spend from cable. So we won't have a good picture for next year's cycle until certainly later this year. But I think as long as bandwidth continues to be a driver, and I don't see anything in the cable space that says bandwidth's not going to continue to be a driver, I'm comfortable that that market is going to continue to be good. And I actually think we have an opportunity to grow overall in the cable space, leveraging the relationships the Transmode is bringing to the table.

[Meta A. Marshall:]

Great. Thank you.

[Thomas J. Fallon:]

Thanks, Meta. (01

[Thomas J. Fallon:]

Thank you for joining us this afternoon and for your questions. We look forward to updating you on our continued progress. Have a great day.

[Operator:]

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