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Author: VTDave Big red star, 1000 posts Ticker Guide SC1 Green Captain Motley Fool One Everlasting Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 140  
Subject: INFN 1Q11 Deep Dive Date: 6/1/2011 10:46 PM
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Hi Fools,

Here are my thoughts on 1Q. Hope it's helpful. As always, comments/corrections are welcome!

INFN 1Q11 UPDATE

Current Valuation (5/23/11)
Price: $6.99
P/E: N/A
FCF Yield: 0.1%
P/S: 1.6
CAPS rating: 5-stars
Founded 12/00; IPO: 6/07

1Q11 Results
Revenue: $92.9M (-20.6% Seq., -3.0% YoY)
EPS: ($0.16) (-83.0% Seq., 29.6% YoY)
FCF: ($11.5M) (N/A Seq., -79.0% YoY)
GM: 46.1%
Cash / Debt: $111.4M / $0.0
1Q Diluted Shares: 103.4


Financial Data (GAAP, $M, *= Based on TTM data)
Qtr Rev.* N.I.* FCF* EPS* ROE* GM% Price Range P/E Range FCF Yld Range P/S Range
1Q11 451.5 (24.3) 0.8 (0.24) (5.9%) 46.1% 6.99 – 7.92 N/A – N/A 0.1% - 0.1% 1.6 – 1.8
4Q10 454.4 (27.9) 9.8 (0.29) (6.8%) 48.8% 7.34 – 8.77 N/A – N/A 1.1% - 1.3% 1.6 – 2.0
3Q10 427.5 (43.9) 40.9 (0.45) (11.0%) 49.6% 7.95 – 8.74 N/A – N/A 3.5% - 4.9% 2.0 – 2.7
2Q10 380.8 (64.8) (4.8) (0.67) (17.4%) 42.5% 8.05 – 12.83 N/A – N/A N/A – N/A 2.1 – 3.3
1Q10 338.3 (82.3) (41.5) (0.86) (22.5%) 38.8% 5.76 – 10.00 N/A – N/A N/A – N/A 1.7 – 2.9
4Q09 309.1 (86.6) (48.0) (0.91) (17.6%) 37.9% 6.79 – 10.05 N/A – N/A N/A – N/A 2.1 – 3.1
3Q09 318.3 (74.6) (109.6) (0.79) (15.6%) 33.2% 7.22 – 9.37 N/A – N/A N/A – N/A 2.2 – 2.8
2Q09 355.4 (43.2) (57.8) (0.46) (9.0%) 29.3% 6.77 – 8.65 N/A – N/A N/A – N/A 1.8 – 2.3
1Q09 447.6 26.8 (19.2) 0.26 5.5% 30.0% 7.17 – 10.38 27.6 – 39.9 N/A – N/A 1.5 – 2.2
4Q08 519.2 78.7 (3.0) 0.81 15.5% 23.0% 5.72 – 9.44 7.1 – 11.7 N/A – N/A 1.0 – 1.7
3Q08 495.9 81.4 36.0 2.80 16.1% 45.0% 6.64 – 10.06 2.4 – 3.6 3.7% - 5.6% 1.3 – 2.0
2Q08 437.6 61.0 20.8 2.58 16.1% 49.5% 6.25 – 11.75 2.4 – 4.6 1.8% - 3.4% 1.4 – 2.6
1Q08 334.9 (8.0) 8.4 1.04 (2.4%) 55.4% 7.92 – 14.28 7.6 – 13.7 0.6% - 1.1% 2.3 – 4.1

Revenue Distribution History
Qtr Domestic YoY Int’l YoY
1Q11 68.7M (9.6%) 24.2M 22.2%
4Q10 81.9M 23.3% 35.2M 48.0%
3Q10 94.4M 78.4% 35.7M 17.0%
2Q10 90.2M 103.7% 21.2M (14.0%)
1Q10 76.0M 54.2% 19.8M 14.5%
4Q09 66.4M (8.7%) 23.8M (10.9%)
3Q09 52.9M (45.9%) 30.5M 34.4%
2Q09 44.3M (66.1%) 24.6M (19.1%)
1Q09 49.3M (55.7%) 17.3M (35.4%)
4Q08 72.7M 16.9% 26.7M 92.1%
3Q08 97.8M 93.7% 22.7M 94.0%
2Q08 130.7M 176.3% 30.4M 173.9%
1Q08 111.4M 179.2% 26.8M 188.2%


2Q11 Guidance (non-GAAP)
Revenue: $92-$97M
GM: 40%
Operating Expenses: $50M
Operating Loss: 11M
Net Loss: $14M
EPS: ($0.12) – ($0.10)

Discussion
Last quarter, INFN shares took a beating when Tom Fallon reported that they were losing business due to not having a 40G solution until “mid 2011,” and that expenses would be higher as they made the march toward volume ramp of their 40G and 100G systems. In 1Q11, INFN basically told the same story and the shares have taken it on the chin again, despite real progress towards the industry’s most cost-effective 100G solution, which will be the major source of revenue growth for years to come. Immediately afterwards, JP Morgan downgraded INFN and slapped a $6 price target on the shares.

So is INFN a company on the ropes? Let's see...

Revenue
Revenue for the quarter was $92.9M, in the lower range of their guidance ($90M - $97M) but down 3% from a year ago. TTM Revenue came in at $451.5M, an increase of 33.4% from the same period one year ago. They managed to add 4 more customers to their roster, bringing the total number of customers to 86. This was the most number of new customers that they have won in a quarter in the past year.

New Customers
Qtr New Total
1Q11 4 86
4Q10 3 82
3Q10 2 77
2Q10 1 75
1Q10 5 74
4Q09 3 69
3Q09 4 66
2Q09 4 62
1Q09 2 58
4Q08 7 56


In addition, INFN continued to see strong shipments to customers who are continuing to build out their existing INFN networks, again beating their stated goal of 2,400 TAMs shipped in a quarter.

TAM (Tributary Adapter Modules) Shipments
Qtr Number
1Q11 >2,400
4Q10 >2,400 (even though Level 3 was only at 10.2% of sales)
3Q10 3,000
2Q10 2,400
1Q10 ~2,000
4Q09 “A good deal less than 2,000” (blamed on general economic conditions)
3Q09 “Below normal, 100 more than 2Q09”
2Q09 “Above 2,000”
1Q09 “A good deal less than 2,000”
4Q08 “A good deal less than 2,000”


In the past, INFN has relied on a few hefty customers for their revenue. But this quarter, Level 3 was their only 10% customer. And even though they made up 14% of revenue, that still seems to be somewhere in the middle of where they typically have been. A while ago, Level 3 announced they were switching to Huawei, but INFN has clearly done a nice job of keeping them as a customer for many quarters now. In my mind, there is no reason to think that they will not continue to do so. Here’s Tom Fallon:

"We continue to have a very good relationship with Level 3. We continue to have the opportunity to win a new business and new routes. But Huawei is clearly being deployed in their network and it's because they are doing it at a CapEx level that quite frankly we don't think anybody can make money at. I think that Level 3 would agree that we offer much lower total operating cost, but at [that] CapEx level, they find that solution very compelling for parts of their application. But we continue to win business. We continue to have a very good relationship and we're going to continue to work to be their primary supplier."

Here is the history of 10% customers:

Qtr Num Level 3 Pct
1Q11 1 14%
4Q10 1 10.2%
3Q10 2 19%
2Q10 4 10%
1Q10 2 22%
4Q09 2 12%
3Q09 3 <10%
4Q08 1 9.9%
3Q08 2 27%


So their revenue was a bit light, but they won new customers, sold a bunch of TAMs, and did this all with only 1 10% customer. What’s the issue? It’s this:

Our first quarter results reflect stable bandwidth demand from our terrestrial and subsea customers, evidenced by strong TAM purchases at the quarter. However, we saw slower new footprint productivity in Q1, versus a year ago as certain of our customers and prospects await the introduction of our new higher capacity products later this year and some have opted for competitive 40G solutions in the interim on a tactical basis."

And this

Capital expenditures were $10.6 million in Q1 versus $5 million in Q4. As discussed last quarter, we expect cap and additions to be approximately $40 million for the year as we add manufacturing capacity in advance of the launch of the 100 Gig products."

Neither the increased expenses (resulting in negative cash flow of $11.5M for 1Q) nor the slower demand from customers who want 40G/100G are a surprise. And even though INFN warned us last quarter that this was going to be the case, these are areas of concern. But here are a few important points to keep these results in context:

1. Demand for 40G is low. The market is worried that INFN is losing customers because of their lack of a 40G solution. And if they lose customers to 40G (the thought goes) they will also lose customers to 100G. However, in reality the company is losing very little business at the moment. 40G just doesn't offer much more value than 10G, and the industry is still waiting for 100G to become affordable. Most customers are simply putting network expansion on hold or are getting huge discounts from INFN to stay on 10G (thus explaining the 3% drop YoY in revenue). However, for those customers who are up against fiber exhaustion right now, the only choice is a band aid – buy 40G now for specific fibers routes and tread water until 100G. Here’s Tom:

"As our customers deploy 40G capability, we see them doing so on a route-by-route basis rather than for long-term strategic reasons. As we work with potential customers, it is clear, they are looking to the economics and capacity of 100 Gig solutions."

And…

"But if you pull back and say, "Who's buying 40G?" Approximately half of it is going to China, and I don't care if we have 40G for free, we're not going to sell any to China. So we're not losing half of an available market, half of the available market is closed to us. The other big portion of the 40G is going to AT&T and Verizon. We haven't won AT&T and Verizon yet. So it's not a choice of can they buy our 10 gig, or our 40G, or our 100G. That market is not available to us today. So if you're to ask me, what percentage of our truly available market are we losing today because of it, it's a very small percentage."

2. Expenses are (rightly) rising at a time when their revenue is down. Last year, the economy was picking up and 10G was in demand because 100G was still far out in the future. This year, revenues are down by comparison. But while their customers aren't building out large new networks, they are continuing to buy cards to fill existing network capacity. As a result, INFN gave TAM guidance that next quarter will again be above their target of 2,400. That's not exactly knocking the cover off the ball, but it shows that their business isn't exactly evaporating either.

In light of the revenue picture, it's nice to know that INFN has $111M in the bank and 0 debt. But it was also nice to hear that they are being careful with expenses. Here’s Ita (the CFO):

…obviously with the revenue where it is, we are trying to kind of reduce that [OpEx] and put pressure on that outside of key sales and R&D and operations headcount where we really need to do that. To support the 100 Gig we have deferred hiring et cetera and we'll continue to do that. I think the $50 million for this quarter, we're definitely trying to stay in that window for the year and also obviously looking for opportunities to kind of take some more cost out."

In 1Q11, they came in at $48.1M for Operating expenses vs. their guidance of $50M. And they are expecting to again spend $50M this quarter, which will hurt their margins. I like that they will continue to cut where they can, but given their overall position, I don’t mind them spending now and taking a margin hit now for 100G later.

3. 40G will now ship in 3Q11
When they come out with their 40G solution, it will be 2x the bandwidth of other industry solutions. The performance was consistent with what they said in 4Q. However, Tom changed the date in the call. Previously, he said that 40G would ship in “mid 2011.” In the 1Q call, Tom said 3Q. Here is how he defended this slip:

"Our stretch timeline frame is Q2 and our commitment was Q3, internally. So we are roughly operating within the window that I had anticipated. Clearly, I was hoping to get it out closer to Q2. You will see us introduce it intently at the first part of Q3 or still in Q3. So I don't want to negate that mid-year is probably like end of June, but we operate within our window of what we'd expect it, the engineering deliverable frame of control could be."

I think Tom is being honest in admitting that he missed the 2Q expectation that he set. And if they do make it end of June, I’m willing to cut him some slack. But why does it matter? As they have already stated, the industry is not going to 40G in huge volumes, so I don’t expect their revenue to suddenly spike here. I think it matters for three reasons:

(1) There is some additional revenue that they will get by selling a 40G interim solution.

(2) The availability of an INFN 40G product should help to ease the perception that they are currently losing significant business.

(3) The availability of INFN's 40G solution will allow them to stop deeply discounting their current hardware. Stop and think about it. If you are a customer, and you know that INFN has no 40G solution, what are you going to do? INFN has absolutely no leverage right now. So you'll threaten to go to someone who has 40G unless they cut their price. And this is exactly what INFN has been doing:

"If somebody is interested in moving to 40G, we are certainly responding with commercial opportunities on 10G pricing to have them defer that decision until we can bring 40G out or our 100G program. And I suspect that it's not unique to us.?"

4. All eyes are on 100G
As beneficial as the 40G system will be, everyone is (correctly) focsed on 100G. Tom announced on the call that 100G will be available in 4Q11 (launch), with volume shipments in 1H12. The final product will be 5 channels running at 100G for a total bandwidth of 500G. They believe this will be the standard for multiple years to come. Their system is currently in DVT (which from my experience means Design Validation Test, but I can't be certain in their test methodology) and stresses the hardware to ensure reliability. That means that they must have a bunch of hardware in the lab under various environmental conditions. It sure seems like significant progress is being made and, barring any major reliability issues, is on track for their volume ramp schedule.

Conclusion
I expect more of the same in 2Q: more 10G discounts, flat or slightly lower revenue, high expenses, but also one step closer to new products. For the reasons I outlined above, I also expect that when their 40G system ships (let’s hope for end of June), it will likely stabilize the stock price, although by no means is it the final answer.

Of course the big payoff is 100G. But when will that revenue show up? Tom announced in the call that the 10G announcement will come in 4Q11, but don’t get too excited about that. Tom also filled in more details of how things will play out and here is the path, as best I can put the puzzle pieces together.

4Q11 Announce --> Lab certification --> FCS --> Revenue

From the call, they are announcing in 4Q so that they can quickly get systems into their customer’s labs. Depending on the customer, lab certification might take anywhere from “a short period of time” up to a quarter. Then, the FCS process begins (I'm not sure what FCS stands for, but I believe it is field certification) which again might be up to a quarter delay (I’m guessing). Tom also mentioned that he is expecting another 1Q delay between FCS exit and revenue. Add all of that up, and it seems that INFN is likely to see a trickle of 100G revenue in 2Q, but not have anything significant until 3Q. I was hoping for revenue a bit earlier, but it still places INFN right at the front of the expected 100G transition:

"One, we're comfortable with the schedules that we've laid out and I'm very comfortable that we are going to be, what I would consider the very early phases of a 100G market that is going to last for a very long time. The number of 100G waves sold today is very, very small no matter, which reports or analyst you look at. Most of the deployments of 100G really don't begin until 2013 and 2014. I think by having our customers be aware of our technology today, by our customers being able to see the products in very near term and is launching in Q4, we are going to be positioned at the very early phase of a very long 100G cycle. I couldn't be more comfortable with the timing that I think the market requirement and our availability are quite frankly perfectly aligned."

With the prices so low right now, I’ve been very tempted by the Jan 2013 LEAPs as a possible play here. But the more I’m looking at the schedules and expected industry adoption, the more I think this is still a 2-year play. 100G revenue will be in the back half of 2012 and into 2013 as the industry really starts to move. I do see INFN revenue (and hopefully the stock price) increasing until that time, but it seems to me that the "pop" might be out further than the Jan 2013 expiration. So while I believe there still may be an opportunity there (I do own some LEAPS I purchased prior to this report), I’m sticking with a long stock strategy for now.

At the current price of right around $7.00, I’d say that the market is pricing INFN as if 100G were never going to happen. And so I’ll be happy to take advantage of a sub-$7 price. I’m thinking that when 40G ships, we will start to see the price stabilize and trend up, through the 100G launch. But who knows. This investment clearly has required and will continue to require patience. But in taking advantage of the prices now, I think I’ll be pretty happy when 100G starts shipping in volume. I’ll leave you with this comment from Tom:

"...the 100G cycle is probably going to be 15 to 20 years or more. The 10G cycle started in 1997. So we're 13 years into it. We didn't bring out our 10 gig solution till 2005. So we caught it in the middle of the cycle. We should have a very good opportunity coming in at the early part of the cycle, making the capital investment at the early part of the cycle, that we can actually have a very, very good business model as these volumes take into the industry, we can accelerate the demand… I think the 100 gig opportunity is the first time that we actually get to test our business model."

Test away!

-Dave.
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