Infinera’s Bear Case – It May Not be That Bad

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A few months back I expressed my concerns about Infinera’s (NASDAQ: INFN) ability to succeed in a cutthroat telecom market.  At the time, Infinera traded a little over $6, about 30% off its 52-week high.  Since then, its share price has plummeted to all time lows under $5.

I like Infinera. DTN-X is recognized by many to be technically the best optical product in the sector.  There is a growing demand for their product, as legacy optical networks have to be replaced to cope with the massive data usage explosion.  Infinera is relevant.

The reason why anyone would invest in Infinera is a chance at multi-bagger returns.  In order for that to occur, Infinera must capture significant market share with the Tier 1 Service Providers. That I am skeptical about.

  • Infinera is not profitable and is inconsistent in generating positive cash flow.  They exist since 2000 and have been public since 2007.  There are reasons why that is, but it still is not good. That should raise a red flag.
  • Infinera has been unable to secure a Tier 1 service provider for its DTN platform.  I have sold optical networks to Tier 1 clients in many countries.  Infinera was rarely mentioned or considered. When I asked, I always got the same answer: “We are a Tier 1 Service Provider that deals with Tier 1 Equipment Vendors.”  In other words, Infinera is too small.  What has changed?
  • With a fragile global economy, in a highly competitive market, Tier 1 Service Providers are increasingly centralizing their purchasing organizations to drive savings.  Last year France Telecom and Deutsche Telekom created an equipment purchasing Joint Venture targeting to reduce their CAPEX spend by €1.3 billion annually.  The basic logic is: The bigger the contract we can offer our equipment vendors, the bigger the discount is that we will be able to negotiate.  Companies like Ericsson (NASDAQ: ERIC), NSN, Huawei, and Alcatel-Lucent (NYSE: ALU) with much wider product portfolios and complementary professional services Tier 1s need, are much better positioned to balance these negotiations in other contracts compared to a single solution company like Infinera (though one of the Tier 1 Service Providers’ shortsightedness has contributed to the financial troubles of their biggest infrastructure equipment suppliers).  I am not convinced that even if Infinera is able to overcome the perception they are too small to deal with the Tier 1s, that they could beat their bigger peers in this game, nor do I believe this would be in their best interest.
  • A realist will recognize that politics play an important game in vendor selection. Alcatel-Lucent, Ericsson, Nokia Siemens are in trouble and the crisis in Europe is dragging them down further.  Even price killers Huawei and ZTE are having problems.  The Tier 1s know it is in their best interest to protect their biggest equipment vendors.  Budgets are tight and larger portions will be allocated to the biggest vendors.  That spells “trouble” for Infinera.
  • Cable & Wireless selected DTN-X in March 2012.  Vodafone bought C&W in June 2012.  Why have I not seen an announcement that Infinera was selected by Vodafone as one of their global strategic suppliers?  It has been almost 6 months.
  • This is a murderous sector where margins are hard to come by.  Infinera’s margins are just north of 35%.  That is dangerous territory.  In this sector you want to see them in the lower to mid 40s. Chances are that Infinera probably has to buy themselves into the Tier 1s if they want to capture market share.  Lower prices equals margin contraction, and before you know it Infinera’s “profitability” sits in Alcatel-Lucent range (low 30s, high 20s).  That is not where you want to be.

I just cannot see Infinera secure enough Tier 1 contracts to build the volume they need at the price points they require to drive long term healthy profits.  Many of us have seen this happen in the past (combined with some desperate mismanagement) in wireless with the deaths of Motorola (split up), Nortel (killed), and Lucent Technologies (merged), all of whom had good technology.

There is a future.  Infinera’s technology is best in class.  When there is confidence that DTN-X is adopted in the market, it could become an acquisition target.  Maybe a larger name that wants to integrate an optical portfolio with its IP Routers to offer a more complete and simplified next generation network infrastructure solution to support 4G LTE and beyond?  It is exactly what Service Providers are seeking. 

Will Infinera’s share improve over the next 4 to 8 quarters?  I think so.  I just do not believe it will offer the 5 or 10 bagger returns many look for.

BEF1973 has a positions in the stocks mentioned above. The Motley Fool owns shares of Infinera. Motley Fool newsletter services recommend Infinera . Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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