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It's Time for Infinera

Pamela is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Founded in 2000, Infinera Corp. (NASDAQ: INFN) went public in June 2007 with the conviction that their unique, large scale, photonic integrated circuits (PICs) would greatly improve the economics, simplicity, flexibility, reliability and scalability of optical communications. For their shareholders, it has been a rocky road, as it has for anyone invested in the optical networkers. However, the pieces are falling into place for Infinera and I believe that investors with long-term views will be well rewarded.

Why Infinera? They have a Moat and they have Delivered

Infinera is a vertically integrated provider of optical networking systems to the telecommunications, cable and internet industries -- or “Service Providers” -- based in Sunnyvale, Calif. They pioneered the development of the PIC, the building block for their products.  Their proprietary PICs are key to their competitive advantage. Infinera manufactures and packages their PICs in their own factories in California and Pennsylvania for their exclusive use. The multi-disciplinary approach required to develop their PIC together with a combination of trade secrets, patents and contractual protections will make it difficult for others to duplicate their technology.  Manufacturing their own critical components and not selling them to others further protects their technology — a strategy also used by another successful company, IPG Photonics Corp.  Vertical integration allows them better quality control and tighter control over delivery times.

Infinera builds only large scale, indium phosphide (InP) PICs, which incorporate all the optical functions necessary for the long haul optical transport of multiple wavelengths on a single chip. Important advantages of this technology are fewer components, reducing the connections needed between them, smaller products and lower electricity consumption per bit.

Each optical chip must be connected to others via optical fibers. During shipment, these tiny fibers can break resulting in the equipment not working when it reaches the customer. Minimizing connections results in higher reliability. To date, Infinera's PIC itself has never failed in a customer network.  In March 2011, Infinera announced over 500,000,000 hours of failure-free operation worldwide. For perspective, 500 million hours is approximately 57,078 years.

Customers confirm their claims that leadtimes are only 10 days vs. as much as 8 weeks for competitors' products and that their products are easy to deploy.

Starting with 41 customers in 2007, two of which accounted for 47% of sales, Infinera has successfully diversified its customer base and last month reported 102 customers with none representing more than 10% of sales.

Although sales have been choppy due to macro-economic uncertainties constraining customers' capex spending and their being competitively disadvantaged with respect to higher capacity opportunities until the release of their 40Gbps product in Q4 2011, sales for the first half of 2012 are up 5.1% vs. H1 2011.   


<img src="/media/images/user_13066/infn-qtrly-sales-2009-2012_html_m1e5a61c5_large.gif" />

Infinera's Performance vs. the Competition

Infinera's competition includes networking giant Cisco Systems (NASDAQ: CSCO), Ciena Corp. (NASDAQ: CIEN), Alcatel-Lucent, Ericsson, Hauwei Technologies (second largest networker by sales) and ZTE Ltd. As the following chart from MSN Money shows, the stock performance of these companies over the past year has not been pretty.


<img src="/media/images/user_13066/chrtsrv_infn-vs-competition_large.gif" />

Cisco and Ciena are the only two up over the past year. Ciena's pop at the end of May was largely due to their reporting a non-GAAP profit of $0.04 vs. expectations for a loss of $0.03 following two previous consecutive quarters of misses and their stated belief that demand in the second half would be strong. Although Infinera met their stated objective of shipping their new DTN-X 500G technology in June, shipments only started in late June — too late for any revenue to be recorded in Q2. This, combined with customers' delaying orders in anticipation of this new technology, caused Q2 sales to drop Y/Y. Even though Infinera beat non-GAAP EPS expectations handily in the previous three consecutive quarters, the market punished them for the penny miss in Q2 2012.

From the perspective of sales growth from 2008 though 2012 YTD, Infinera has done quite well relative to the competiton. Sales growth beat or kept pace with their non-Chinese competition except in 2011. (I discount Hauwei and ZTE only because their government has such a large influence on their business.) Ciena's spike in 2010 was due to their substantial acquisition of Nortel's Metro Ethernet Networks in March 2010, which more than doubled sales compared to 2009.

<img src="/media/images/user_13066/infn-sales-vs-competition_html_7d5baeaa_large.gif" />

Infinera's Performance Compared to their Customers' Capex Spending

From 2008-2010, Infinera's announced publicly traded customers in their SEC filings consisted of Deutsche Telekom, Global Crossing and Level 3 Communications (NYSE: LVLT). In 2011, this list grew to include Equinix, Inc. (NASDAQ: EQIX) and Nippon Telegraph and Telephone. The following graph compares Infinera's change in annual sales with these customers' change in capex.


<img src="/media/images/user_13066/infn-sales-vs-customers-capex_html_m28fa61cb_large.gif" />

Infinera's 43.8% sales growth in 2008 was remarkable given the big decline in capital spending by their largest customer then, Level 3 (25% of sales). Between 2008 and now, their sales have held up very well despite big swings in these customers' capex. In July, 2009, Level 3 announced that they would be adding a new vendor and reducing purchases from Infinera. Last year, Level 3 acquired Global Crossing, potentially further cutting into Infinera's sales.

Potential Catalysts

The addition of Equinix as a customer should prove very profitable because Equinix's capex is 37-43% of sales vs. 10-12% for Level 3 and 14-15% for Deutsche Telekom and their sales have been growing 20-30% annually. Although Equinix's capex for the first half of 2012 was only $318 million, in their Q2 report they forecasted total capex for 2012 of $740-800 million. NTT's capital spending is expected to exceed their goal of 15% due to the need to replace earthquake-damaged equipment, but in their 20-F for the year ended 3/30/12, they said: the “NTT Group aims to make significant improvements in its Capex Ratio by enhancing the efficiency of its capital expenditures.” This looks like a good opportunity for Infinera.

In their Q2 conference call, they mentioned that Cable & Wireless Worldwide and Dante had ordered the DTN-X.  Infinera admitted that they are courting Verizon Communications.  Verizon had endorsed Infinera's architecture, but no sales yet.  With capex of $16.2 billion last year, even a small piece of that would be significant.

In their outlook for the rest of 2012, Infinera stated their order book was strong.  They would be recognizing 10 DTN-X purchases from the end of Q2 in their Q3 revenue and had 8 to 10 trials already scheduled for Q3 and interest in DTN-X was strong.  Second half sales were forecasted to be $230-245 million, which would mean a Y/Y sales increase of 7-9.5%.

Global smartphone shipments are expected to increase from 494 million units last year to 1,161 million in 2016 for a CAGR of 18.6% increasing the need for bandwidth. Deutsche Telekom noted that 62% of all cell phones sold in Germany in 2011 were smartphones vs. 50% in 2010. 

Finally, a longer term catalyst is Google. Google just announced pricing for their ultra-fast internet service in Kansas City last week. It's too early to know how popular it will be, but at $120/month for internet service 100 times faster than a cable modem and cable-like TV, it's $10 less a month than I am paying for the slowest internet speed Comcast offers plus their Digital Starter TV service. Although Google pulled their own fiber optic cable for this test market, Google can expedite nationwide rollout of their new service by making use of the thousands of miles of dark fiber (unused fiber optic cable) available in the US and Infinera's DTN-X technology is tailored-made for this application.

Things that Could Hurt Growth

The slowdown in the Chinese economy as reported by the Financial Times on July 29 is going to make Huawei and ZTE hungry for sales elsewhere, which could lead to downward pressure on prices. Although national security concerns are presently keeping Huawei at bay in the US, about 30% of Infinera's business is international. Ciena also noted in their 10-Q for their April 2012 period: “We expect the level of competition, particularly in North America, to continue and potentially increase, as Chinese equipment vendors seek to gain entry into the U.S. market, and other multinational competitors seek to retain incumbent positions with large customers in the region.”

Cisco recently acquired privately held Lightwire and moved optical networking out of Other Products into their Next Generation Network (NGN) group, acknowledging its greater importance and potentially their greater investment in this area.

Although many network providers have forecasted increasing bandwidth demand, macro-economic uncertainties are keeping some Tier 1 providers like AT&T Inc. and Verizon from expanding their capex much if at all this year.

Bottom Line

Infinera's DTN-X technology is superior to the competition and customer interest is strong. Short leadtimes are ideal for customers trying to delay purchases to the last minute. Smartphone sales continue to grow and even if the telecoms restrain their capex this year, they can't do so forever or risk losing their best customers. Patient Infinera investors will be rewarded and the recent drop in their stock makes it especially attractive now.



p366 owns shares of Infinera. 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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