This quarterly report on Form 10-Q contains "forward-looking statements" that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. Such forward-looking statements include any expectation of earnings, revenues, gross margins, costs, restructuring charges and associated costs, or other financial items; any statements of the plans, strategies and objectives of management for future operations and personnel; factors that may affect our operating results, including sales and equipment deployment; statements concerning new products or services; statements related to capital expenditures; statements related to future economic conditions or performance; statements related to market growth; statements related to repayment of our adjustable rate securities; statements as to industry trends and other matters that do not relate strictly to historical facts or statements of assumptions underlying any of the foregoing. These statements are often identified by the use of words such as "anticipate," "believe," "continue," "could," "estimate," "expect," "intend," "may," or "will," and similar expressions or variations. These statements are based on the beliefs and assumptions of our management based on information currently available to management. Such forward-looking statements are subject to risks, uncertainties and other factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled "Risk Factors" included elsewhere in this Form 10-Q and in our other Securities and Exchange Commission filings, including our annual report on Form 10-K for the year ended December 27, 2008 filed on February 17, 2009. Such forward-looking statements speak only as of the date of this report. We disclaim any obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements. The following discussion and analysis should be read in conjunction with our condensed consolidated financial statements and notes thereto included elsewhere in this quarterly report on Form 10-Q.

Executive Overview

Infinera Corporation ("we" or "Infinera") has developed a solution that we believe will change the economics, operating simplicity, flexibility, reliability and scalability of optical communications networks. At the core of our Digital Optical Network architecture is what we believe to be the world's only commercially-deployed, large-scale photonic integrated circuit ("PIC"). Our PICs transmit and receive 100 Gbps of optical capacity and incorporate the functionality of over 60 discrete optical components into a pair of indium phosphide chips approximately the size of a child's fingernail. We have used our PIC technology to design a new digital optical communications system called the DTN System. The DTN System is architected to improve significantly communications service providers' economics and service offerings as compared to traditional systems. Our DTN System is designed to provide faster service delivery and network management flexibility. Our carrier-class DTN System runs our Infinera IQ Network Operating System and is integrated with our Infinera Management Suite software, which together enhance and simplify network monitoring, management and control. In 2008, we introduced the Infinera Line System 2 ("ILS2") which is designed to extend the reach and optical capacity of our DTN System.

In October 2009, we launched our ATN product which extends Infinera's digital optical networking benefits into the metro environment by providing a small form-factor, cost-efficient metro solution that integrates with Infinera's DTN System. We believe that this functionality provides greater efficiency and additional savings to our customers over conventional metro solutions.

Our goal is to establish our Digital Optical Network, based on photonic integrated circuits, as a leading architecture for optical communications networks. We believe that photonic integrated circuits will significantly change optical communications networks in a fashion similar to the integrated circuit's impact on electronics beginning in the 1950's. As of September 26, 2009, we have sold our DTN System for deployment in the optical networks of 66 customers worldwide, including Cox Communications, Deutsche Telekom, Global Crossing, Interoute and Level 3 Communications ("Level 3"). We do not have long-term purchase commitments with our customers. To date, a few of our customers have accounted for a significant portion of our revenue. In the three and nine months ended September 26, 2009, Level 3 accounted for approximately 9.9% and 19.3% of our revenue, respectively. In the three and nine months ended September 27, 2008, Level 3 accounted for approximately 25.6% and 26.5% of our revenue, respectively. As previously disclosed, on July 29, 2009, we were informed by Level 3 that they intended to use another DWDM vendor in their network. We believe that this vendor will be given a significant portion of Level 3's new network deployments commencing in the first half of 2010. Level 3 has informed us that they intend to continue to purchase products and services from us, including equipment with higher margins to fill the capacity on their existing Infinera DTN Systems. We continue to assess the impact of the introduction of this other vendor on the future revenues that we will receive from Level 3 beginning in the first half of 2010. In addition, we continue our focus on customer diversification, with three of our customers, excluding Level 3, representing more than 10% of our revenue in the third quarter of 2009.

We believe that rapid growth of communications traffic and proliferation of next-generation bandwidth-intensive services such as video will expand the need and increase demand for optical network capacity. Our DTN System is designed to serve as the key element for long-haul and metro core optical transport networks of U.S. and international communications service providers. Customer deployments of our DTN System have ranged from two to thousands of network locations.

We are headquartered in Sunnyvale, California, with employees located throughout the United States, Europe and the Asia Pacific region. We expect to continue to add personnel in the United States and internationally to develop our product and provide additional geographic sales and technical support coverage. We primarily sell our products through our direct sales force, with a small portion sold indirectly through resellers. We derived 97% and 93% of our revenue from direct sales to customers for the three and nine months ended September 26, 2009, respectively. We expect to continue generating a substantial majority of our revenue from direct sales in the future.

Our historical revenue trends have been significantly impacted by the timing of our attainment of vendor specific objective evidence ("VSOE") of fair value for most of our services and are not indicative of revenue trends in 2009 and future periods. Prior to the first quarter of 2008, revenue from product sales sold in combination with services ("bundled product sales") was deferred and recognized ratably over a period of approximately one year. This resulted in the accumulation of $174.4 million of deferred revenue and $81.6 million of associated deferred inventory costs on the balance sheet as of December 29, 2007. We recognized $165.8 million of this deferred revenue and $78.4 million of associated deferred inventory costs in 2008. In addition, the attainment of VSOE of fair value for most of our services beginning in the first quarter of 2008 required us to recognize a majority of our 2008 product sales as revenue in the period in which the bundled products were accepted by the customer. The combined effect of the recognition of the deferred revenue from prior periods and the upfront recognition of revenue from bundled product sales in 2008 resulted in increased levels of revenue, gross margin and net income for 2008. We do not expect to recognize significant amounts of product related deferred revenue and deferred gross profit in the future.

The table below illustrates our 2008 results as reported and excluding the impact of the recognition of deferred amounts from prior periods:

                                              Year Ended December 27, 2008
                                                                           Deferred
                                                      Pre-VSOE           Revenue and
                                  As Reported         Deferred            Inventory
                                    Results          Adjustments        Costs Excluded
                                          (In thousands, except gross margin)
 Revenue                         $     519,212      $    (165,787 )    $        353,425
 Cost of revenue                       285,657            (78,401 )             207,256

 Gross profit                    $     233,555      $     (87,386 )    $        146,169
 Gross margin                               45 %                                     41 %
 Income (loss) from operations   $      73,433      $     (87,386 )    $        (13,953 )
 Net income (loss)               $      78,728      $     (87,386 )    $         (8,658 )

We believe that these adjusted amounts, as presented in the Deferred Revenue and Inventory Costs Excluded column of the table above, are more indicative of the revenue and gross margins generated directly from our 2008 sales and invoiced shipment activities. We expect our future product revenues and gross margins to approximate our invoiced shipment results with no further significant releases of deferred amounts from prior periods. Our future product revenues will therefore be largely driven by our underlying invoiced shipment trends. Our near term year-over-year and quarter-over-quarter growth in invoiced shipments will likely be volatile and may be impacted by several factors including general economic and market conditions, the timing of large product deployments, acquisitions of new customers and development of new products.

We will continue to make significant investments in the business, and management believes that operating expenses will be approximately $50 million to $52 million for the fourth quarter of 2009.

In July 2009, we announced a restructuring plan under which we will close our Maryland based semiconductor fabrication plant ("FAB") and consolidate these activities into our primary FAB location in Sunnyvale, California. This consolidation of activities in one location is expected to facilitate collaboration across integration platforms in support of our next generation products. As a result, during the third quarter of 2009, we recorded restructuring and other related costs including severance and related expenses, equipment and facilities-related costs, and other exit costs. Equipment and facilities-related costs primarily consist of depreciation associated with restructured assets which refers to the increase in depreciation expense caused by shortening the useful life or updating the salvage value of depreciable fixed assets to coincide with the end of production under the approved restructuring plan. In the three months ended September 26, 2009, we incurred $0.9 million of severance and related expenses and other exit costs. We also recorded non-cash charges of $2.4 million primarily comprised of equipment and facilities-related costs.

The types of restructuring and other related costs recorded for the three and nine months ended September 26, 2009 were:

                                                   Three and Nine Months Ended
                                                        September 26, 2009
                                               Cost of        Operating
                                               Revenue        Expenses        Total
                                                          (In thousands)
    Severance and related expenses           $       804    $          97    $    901
    Equipment and facilities-related costs         1,900              415       2,315
    Other                                             32               89         121

    Total                                    $     2,736    $         601    $  3,337

The following table sets forth the activity and balance of the restructuring liability account for the nine months ended September 26, 2009:

                                                   Severance
                                                      and
                                                Related Expenses
                                                 (In thousands)
              Balance at December 27, 2008    $                 -
              Provision                                        901
              Payments                                        (259 )
              Non-cash charges                                  -

              Balance at September 26, 2009   $                642

We expect to incur approximately $2.0 million of additional restructuring and other related costs through the fourth quarter of 2009 which will mostly be comprised of severance and related expenses, equipment and facilities-related costs, the fair value of the remaining rent payments for an operating lease, net of expected sublease income, and other exit costs. Additional charges may be incurred in the future related to this restructuring, particularly if the actual costs associated with vacant facilities and other restructured activities are higher than expected. We expect to substantially complete our restructuring actions in the fourth quarter of 2009.

The following table sets forth the estimated future timing of total cash payments related to this restructuring plan:

                                                  Severance              Equipment and
                                                     and                  Facilities-
                                               Related Expenses          Related Costs         Total
                                                                  (In thousands)
Estimated timing of future payments:
Fiscal quarter ending December 26, 2009      $                405      $             300      $    705
Fiscal years 2010 to 2012                                     333                    966         1,299

                                             $                738      $           1,266      $  2,004

Beginning in the first quarter of fiscal 2010, we expect to experience an approximate 2% quarterly gross margin improvement as a result of the closure of the Maryland FAB and the consolidation of those activities with our other operations.

Overview of Condensed Consolidated Financial Data

Revenue

We derive our revenue from sales of our products, support and services. Our revenue is comprised of three components: (1) product revenue, (2) ratable product and related support and services revenue, or ratable revenue and
(3) services revenue. Product revenue primarily relates to bundled products that are sold only with services for which VSOE of fair value has already been established and therefore, is recognized upfront under the residual method in accordance with the Software-Revenue Recognition Subtopic of the Codification. Product revenue also includes products that are sold without services or a small amount of product sales where software is considered incidental.

Our DTN System is integrated with software that is more than incidental to the functionality of our equipment. We refer to the integration of our DTN System with our software and related support and services as a bundled product. We recognize the majority of our revenue pursuant to Software - Revenue Recognition Subtopic of the Codification. For arrangements with multiple elements which include product and services for which VSOE of fair value has been established, we allocate revenue to the undelivered element using the residual method based on VSOE of fair value for each of the undelivered elements. However, when these transactions also include undelivered services for which VSOE has not been established, product revenue is deferred and recognized ratably over the longest remaining service period.

Services revenue is comprised of (1) revenue related to services for which VSOE of fair value has been established, (2) revenue related to services which were sold on a standalone basis or (3) revenue related to extended hardware warranty sales.

The following table illustrates our revenue for the three and nine months ended September 26, 2009 and September 27, 2008:

                                             Three Months Ended                           Nine Months Ended
                                    September 26,          September 27,         September 26,         September 27,
                                         2009                  2008                  2009                  2008
                                                                     (In thousands)
Revenue:
Product                           $           73,690     $          76,130     $         193,912     $         226,763
Ratable product and related
support and services                             892                39,495                 3,206               181,462
Services                                       8,826                 4,881                21,802                11,643

Total revenue                     $           83,408     $         120,506     $         218,920     $         419,868

Total Revenue. Total revenue for the three and nine months ended September 27, 2008 was $120.5 million and $419.9 million, respectively. However, revenue for 2008 was unusually high due to the impact of the attainment of VSOE of fair value for software subscription services in the first quarter of 2008 and for training and installation and deployment services in the second quarter of 2008. These changes resulted in the recognition of incremental revenue of $39.6 million and $152.7 million in the three and nine months ended September 27, 2008, respectively, related to reductions in the deferred revenue balance for each period. Excluding this deferred revenue impact, revenue in the three and nine months ended September 27, 2008 would have been $80.9 million and $267.2 million, respectively. This compares to total revenue of $83.4 million and $218.9 million, respectively, for the three and nine months ended September 26, 2009. The $48.3 million reduction in total revenue for the nine months ended September 26, 2009 as compared to the corresponding period in 2008, excluding the deferred revenue impact, was primarily due to reduced sales of our DTN Systems to existing customers in the first half of the year, somewhat offset by the recognition of revenue on a number of large deployments with new and existing customers that were completed and recognized as revenue in the third quarter of 2009.

Product Revenue. Product revenue consists of products that are sold without services or bundled products that are sold with services for which VSOE of fair value has already been established and therefore, is recognized upfront under the residual method in accordance with the Software - Revenue Recognition Subtopic of the Codification. We use the residual method to recognize revenue when a sales agreement includes one or more elements to be delivered at a future date and VSOE of fair value of all undelivered elements exists. VSOE of fair value for software subscription, training, installation and deployment services, spares management and on-site hardware replacement services is determined by reference to the price the customer will be required to pay when these services are sold separately.

We attained VSOE of fair value for software subscription services in the first quarter of 2008, for training and installation and deployment services in the second quarter of 2008 and for spares management and on-site hardware replacement services in the fourth quarter of 2008. $76.1 million and $226.8 million of product revenue was recognized for the three and nine months ended September 27, 2008, respectively, from sales of bundled products and services where the only undelivered element was a service for which VSOE of fair value had been established. As of the first quarter of 2009, we had established VSOE of fair value for most of our services and recognized product revenue of $73.7 million and $193.9 million for the three and nine months ended September 26, 2009, respectively. The decline in product revenues reflects decreases in the underlying product related invoiced shipments primarily due to reduced sales of our DTN Systems to existing customers in the first half of the year somewhat offset by the timing of revenue recognition on a number of large deployments with new and existing customers that were completed and recognized as revenue in the third quarter of 2009.

Ratable Product and Related Support and Services Revenue. Substantially all of our product sales are sold in combination with support services, which consist of software warranty or software subscription services. In addition, we have sold training, installation and deployment services, spares management and on-site hardware replacement services with a significant number of these bundled sales.

VSOE of fair value for support services, training and installation and deployment services is determined by reference to the price the customer is required to pay when these services are sold separately. Support services are comprised of software warranty and software subscription services. Software warranty provides customers with maintenance releases and patches during the warranty support period. Software subscription also includes maintenance releases and patches and provides customers with rights to receive unspecified software product upgrades released during the support period. In order to establish VSOE for these services, we are required to establish a history of selling these services separately at a consistent price.

In the first quarter of 2008, we established VSOE for software subscription services. As a result, we were no longer required to ratably recognize product revenue for sales transactions where products were sold with software subscription. Product revenue from these transactions was recognized upon acceptance, and software subscription services revenue was deferred and recognized over the term of the arrangement which is generally 12 months. In instances where acceptance of the product occurred upon formal written acceptance, revenue was deferred until such written acceptance had been received. Revenue allocated to product sales was included in product revenue; revenue allocated to services was included in services revenue. However, when these transactions also included undelivered training or installation and deployment services for the period, product revenue was deferred and recognized ratably over the longest remaining support period until the training or installation and deployment services were complete. Upon completion of these services, the difference between the VSOE of fair value for the remaining software subscription period and the remaining unrecognized portion of the arrangement fee was recognized as ratable product and related support and services revenue.

The attainment of VSOE of fair value on software subscription services in the first quarter of 2008 resulted in a large proportion of the underlying invoiced shipments being recognized as revenue in that period. Product revenue increased due to our ability to recognize and allocate revenue related to bundled shipments where software subscription was the only undelivered element. In addition, the weighted-average revenue deferral period for current period shipments of bundled products and services was approximately 90 days. These changes resulted in a significant increase in the amount of ratable revenue recognized from invoiced shipments in the first quarter of 2008 and a significant reduction in additions to the deferred revenue balance for the period.

We established VSOE for our training and installation and deployment services in the second quarter of 2008. As a result, commencing in the second quarter of 2008, we recognized most of our shipments as revenue at the time of acceptance and allocated that revenue to the appropriate revenue category in our condensed consolidated statements of operations. This resulted in increased levels of product and services revenue in the second quarter of 2008 and subsequent periods offset by a reduction in ratable revenue.

We had established VSOE of fair value for most of our services by the end of 2008 and as a result, during the three and nine months ended September 26, 2009, we recognized the majority of our invoiced shipments as product revenue at the time of customer acceptance. Ratable revenue for these periods related primarily to a small portion of our shipments where products are sold in combination with software warranty and other services for which VSOE has not yet been established and amounted to $0.9 million and $3.2 million for the three and nine months ended September 26, 2009, respectively.

Services Revenue. Services revenue is comprised of (1) revenue related to bundled services for which VSOE of fair value has been established, (2) revenue related to services which were sold on a standalone basis or (3) revenue related to extended hardware warranty and other non-bundled services. Following the attainment of VSOE of fair value for software subscription services in the first quarter of 2008, attainment of VSOE of fair value for training and installation and deployment services in the second quarter of 2008 and the attainment of VSOE of fair value for spares management and on-site hardware replacement services in the fourth quarter of 2008, we have recognized revenue from delivered training and installation and deployment services, software subscription services, spares management services, and on-site hardware replacement services as services revenue in our condensed consolidated statements of operations. We typically experience volatility in the mix of service offerings included in our services revenue on a quarter over quarter basis. For the nine months ended September 26, 2009, approximately 53% of the services revenue recorded related to software subscription services, with 35% related to installation and deployment services and other services accounting for the remaining 12%.

Deferred Revenue. Following the attainment of VSOE of fair value on software subscription in the first quarter of 2008, the attainment of VSOE of fair value for training and installation and deployment services in the second quarter of 2008, and the attainment of VSOE of fair value for spares management and on-site hardware replacement services in the fourth quarter of 2008, the majority of our . . .