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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 4Q Deep Dive Date: 3/9/2011 8:37 PM
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As promised, here are my musings after going through INFN's 4Q results. Hope it's helpful.


INFN 4Q10 UPDATE

Current Valuation (3/4/11)
Price: $7.97
P/E: N/A
FCF Yield: 1.2%
P/S: 1.8
CAPS rating: 5-stars
Founded 12/00; IPO: 6/07

4Q10 Results
Revenue: $117.1M (-10.0% Seq., +29.8% YoY)
EPS: ($0.03) (N/A Seq., 618% YoY)
FCF: $1.9M (-53.7% Seq., -94.2% YoY)
GM: 48.8%
Cash / Debt: $113.6M / $0.0
4Q Diluted Shares: 101.6M

Helpful Links
Latest News: http://www.reuters.com/finance/stocks/keyDevelopments?symbol...
Insider Transactions: http://finance.yahoo.com/q/it?s=INFN+Insider+Transactions
P/E History Chart: http://ycharts.com/companies/INFN/pe_ratio

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
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
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%


Discussion
After setting the bar low with their 3Q revenue guidance of $115-$120M and non-GAAP earnings between $0.02 - $0.05, I thought INFN’s 4Q numbers were pretty respectable. Revenue came in at $117.1M and non-GAAP earnings were $0.07. Revenue grew 47% YoY. The problem was in what Tom Fallon said next…

“In the near term however there are some opportunities we are missing out on when customers who have an immediate need to increase the fiber capacity in their networks are forced into a short-term 40G decision. We’ll be able to address these opportunities later in the year when we bring our differentiated 40G solution to market and over the longer term with our PIC based 100G solution.”

That, and the commentary and lower guidance that followed, was enough to push the shares over a cliff. But does INFN really deserve that kind of punishment? Let’s take a look…

1. New Customers
In 3Q, they estimated they would win 3 new customers in 4Q, but they actually won 5.


Qtr New Total Seq. YoY
4Q10 3 82 6.5% 18.8%
3Q10 2 77 2.7% 16.7%
2Q10 1 75 1.4% 21.0%
1Q10 5 74 7.2% 27.6%
4Q09 3 69 4.5% 23.2%
3Q09 4 66 6.5%
2Q09 4 62 6.9%
1Q09 2 58 3.6%
4Q08 7 56 14.3%


They also reported that they sold their ATN (metro edge) solution to 22 customers in 2010. This is significant because it is their significant growth driver going forward. I was glad to see that they won more customers in 4Q than they projected, but more new customer wins (as opposed to expanded business from current customers) may be getting harder. Why? Two reasons…

1. 10G technology has essentially matured and thus the value of INFN’s integration is not as great as it once was. In fact, initial cost of their system is now similar to their competition. However, there is still a significant cost of ownership benefit to INFN’s products since they are unique in offering a truly digital optical architecture. That is still a strong argument to buy INFN products, but not as strong as it once was.

2. 100G adoption is right around the corner. Because the cost is through the roof at the moment, not many are opting for this technology yet. However CSP’s (communication service providers) are starting to use 40G as a gap-filler until 100G is ready. I’ll cover this more later, but INFN does not yet have a 40G solution. Thus, they will lose customers who are stuck for bandwidth now.

In the early days, INFN watched their new customer counts closely because it was an indicator of their overall gross margins. In the conference call, Ita Brennan, their CFO explained that this metric is starting to lose significance. Since they now have 82 customers buying TAMs (at a high margin), the effect of new customers buying common network equipment (low margin stuff like chassis) is pretty small. Thus, starting in 1Q11, they will come up with other more relevant metrics in the Q1 report.

2. Customer Mix / Level 3
Level 3 built a ton of bandwidth capability in 3Q because of their deal with Netflix. And you can clearly see that effect as they dropped from 19% of INFN’s business in 3Q to 10% in 4Q. In 4Q, Level 3 was their only 10% customer. But let’s not forget that Level 3 has announced that they intend to transition their business to Huawei, so their future purchases from INFN will eventually decline. The timing of that decline is not very certain as they have a bunch of open INFN TAM slots and it’s more cost effective to fill those empty spaces with INFN cards then it is to convert an entire system to another vender. I’m hoping that there are enough slots to last until after the 100G transition as INFN can sure use the tailwind of their largest customer between now and then. The good news is that Ita said in the Q&A section of the conference call that they expect Level 3 to come back to “historic levels” in Q1, so they are not going anywhere just yet.

10% or greater Customers

Qtr Num Level 3 Pct
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%


3. PIC Roadmap Execution
According to INFN, they will have a 40G product in mid-2011 and 100G “in 2012.” They announced that their 40G solution will be a 6.4TB solution, which they expect to be the highest bandwidth offered in the market, twice the bandwidth typically provided in the industry. They also announced that their 100G solution will include “flex coherent technology,” meaning modulation will be controlled by software to cover a wider variety of customer applications. They have had the 500GB PIC working for a while now and in the call they announced they also have a 5TB switch working.

I still believe that execution of their 40G and especially 100G product is the largest risk here. Both of these technologies are becoming more important every day and INFN can’t afford any delays here. If they screw up either one, it could mean a huge blow to their business.

Since the conference call, INFN announced what I think is a significant 500G PIC field test under the North Sea between Amsterdam and London (http://phx.corporate-ir.net/phoenix.zhtml?c=209747&p=iro...). This is excellent progress and I’m hoping to see more and more field tests to not only help them get the bugs out of the design, but to also show off the technology to new and existing customers.

4. 1Q11 Guidance
For the second quarter in a row, INFN guided lower. They cited some of the same reasons this time (limited customer visibility, many customers recently completed large network build-outs, etc…). The big news though was this:

"We are seeing some increase in opportunities where a higher fiber capacity is becoming a more important criterion for success. We continue to compete for this business using the other benefits of our digital optical network deploying 10 Gig capacity now with a migration to our differentiated 40G line card when it is introduced mid-year. However there are some opportunities in the short term that we are missing out on with customers who would require higher fiber capacity today. The combination of these factors calls for revenue guidance that is based primarily on continued bandwidth consumption with lower levels of new footprint additions in the quarter."

Predictably, the stock took an 18% drubbing from $8.98 to $7.37.

While it is clear that they are losing some deals, it is not clear at all to me that INFN is falling off a cliff. Here is why:

A. 10G is "not dead yet." Sorry, Monty Python was just screaming in my head there... Because of cost considerations, the 10G market is still expected to grow 4-5% next year and INFN should continue to see strong repeat customer business. They may even continue to win new customers because of the efficiency of their digital optical network.

B. 40G Adoption will be limited. A small number of customers are currently transitioning to 40G, again, because of cost. INFN has stated that it takes about a 25% - 30% cost advantage to make the DWDM industry move en masse to a new technology. Today, 40G costs about 4X 10G and so there is really no significant advantage of moving away from 10G, unless you are fresh out of fibers. There are some companies who are facing fiber exhaustion to be sure, but even those companies don’t view 40G as a long-term solution. The goal is 100G. So most will be holding out as long as they possibly can. That is good for INFN and should limit the customer losses that INFN will see.

C. The combination of items #1 and #2 above have spooked the market. When you lower your revenue guidance and then state that you will probably lose customers who need 40G now, it’s easy for analysts to get nervous and think that INFN might lose a bunch of their current customers. But I do not think that is the case. True, 40G is starting to impact them, but here is what Ita had to say:

“It is important to note that we do not believe that we have lost any existing customers but rather that many of our customers are still digesting the expanded 1.6-terabit footprint that they installed 2010.”

In other words, revenues will come in lower because their customers just gorged themselves on bandwidth. Once they digest this new capability (and they absolutely will – just consider the bandwidth requirements of iPhones, Android Phones, iPad, iPad2, Netflix, etc…) they will be back for more. Here are a few quotes from Tom in the Q&A that I found very helpful:

“…I believe that this current low rate in Q1 is not reflective of the opportunity of the market and it is not reflective of our opportunity in the year. From a longer-term guidance I see scenarios based upon fundamental demand and our leadership in 10G that we could have a year that grows certainly off of last year. I see an opportunity based upon the success of short term 40G quite frankly that we could have a flat or down year even. Though I think that that’s less likely.”

“I do not believe Q1 represents a new run rate for our business. Having said that, I do think there is some impact to 40G…. If I look at where 40G is being sold today, it is vastly not into our customer base.”

“Do I think that it [40G] is taking away much of our business? We have lost some deals. So far I don’t think that they have been material to revenue that we would have recognized yet but each quarter it is becoming more impactful and I take it very seriously, I don’t care if it’s one dollar or a million, I take every loss very, very seriously. Having said that, the 10 Gig wave market is forecasted to grow about 20% this year and that will translate to about a 4% or 5% growth in revenue in the industry. I think there is no reason to believe that the heritage of the telecom industry will change that they are willing to be driven by dollar per bit per mile. And 10 Gig continues to be the best economic answer if you are going to move to a 100G as the long-term answer.”

D. Their 40G solution will be a natural upgrade for their own customers. While 40G will be limited, INFN also recognizes that their customers may need to make a switch in the next few quarters as an intermediate step to 100G. If they are able to bring their 40G solution to market in mid-2011, there will be a natural (and fast) upgrade path for their current customers. Thus, they believe 40G will materially help their business this year.

E. If they execute well on 100G, INFN will be positioned to take a significant share of the 100G market. When INFN comes out with their 100G solution, it will have a large price advantage, much the same as their 10G products. When combined with the integration and efficiency of a PIC-based digital optical network, their 100G solution should have very broad market appeal.

Conclusion
There just doesn’t seem to be that much mystery here. If they can pull off their roadmap, they can be very, very successful. If they mess it up, they could take a huge step backwards and have a very murky future. So far, the news seems very positive and I believe that they remain on track. If there were a problem on either product, I believe we would have heard something in the conference call.

Management seems very forthcoming, honest, and willing to quickly recognize real issues. Since they reshaped their roadmap in May 2010, they have consistently said they would deliver 40G in 2011 and 100G in 2012. All of their messages have made sense to me. So if they really can execute on this roadmap (and I can’t see why they can’t)…. Wow… I believe that they are in a position to take tremendous market share from the competition. Remember, INFN got to where they are today by entering the 10G space 7 years late in the adoption cycle and now they own 30% of the US DWDM market. What do you think will happen if they get to 100G just when the industry is just starting to convert?

In order to go to high volume quickly, especially on 100G, they will start cranking up the operating expense to develop significant PIC and systems manufacturing capacity (space, equipment, headcount, materials, etc…). They are also going to increase their sales force. As a result of all of this, they believe that their GMs will take a hit of about 2% in 1Q. I see these as necessary expenses to make these products happen and I’m certainly wiling to give up a bit now to secure a bright future.

Of course there are no guarantees, but I continue to be optimistic about their potential. No one else in the DWDM market is able to offer the same amount of integration (read: cost savings, reliability, and power efficiency) as INFN. No one else can touch their system cost, especially at the front end of a technology. No one else offers the benefits of a digital optical network. And no one else can compete because there is no other PIC-based system solution (although NeoPhotonics now offers PICs, they are simply a parts company and do not offer end-to-end solutions). Combine all of that with excellent management, a bunch of really smart people (http://phx.corporate-ir.net/phoenix.zhtml?c=209747&p=iro...) and it seems that the potential reward here is well worth the risk.

As to valuation, I think Mr. Market is being overly shortsighted. The day after earnings multiple analysts downgraded the stock. Yes, they guided lower for 1Q. Yes, they will spend more OpEx. But I’m invested for 1Q11. I want to see what happens with 100G in 2012. So I see these prices as excellent opportunities to acquire shares.

Shares are currently trading at $7.97 with a P/S of 1.8. On a P/S basis, that is essentially as low as it’s been since mid-2009. After the released earnings, P/S went as low as 1.6. You’d have to go back to 1Q09 to see that level. Since reporting earnings, shares have essentially bounced between $7.50 and $8.50 and probably will continue to hang around until next quarter’s results. If they meet their guidance and have a good 40G story, I think we’ll see the share price steadily rise until the 40G product is actually announced. I have a full position now, but if shares hit $7.50 again, I plan to take a fairly significant trading position. Worries over the Middle East and oil process just might let me scoop them up at that level.

This company is all about 100G right now. If they execute, I think they win, and probably win big. Here’s what Tom had to say on that point:

“The addition of our 100G technology to our optical platforms will combine increased fiber capacity with unique features of the digital optical network. Further we believe that Infinera and its customers will experience the same competitive advantages that we began delivering to customers with the DTN system in 2004 that resulted in our rapid market share gains.”

If that happens, I believe shareholders will be very happy.

-Dave.
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