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Infinera Corp.'s "Yeah Baby" Moment


...this has all the makings of a disruptive technology emerging just at the right time.

One of the toughest things in this business is to match your investment thesis with the right company. We all have visions of "big opportunities" waiting to be exploited, but we rarely stumble on the perfect vehicle to exploit them. And then, once in a blue moon, you come across what you perceive to be "The Answer"; that company that you believe is right in the center of the next big thing. You have a "Yeah Baby!" moment. It's a rare occurrence, and even when it happens there still remains the long road of execution, good management, and shear luck that needs to be traveled before the "Big Thing" becomes big money. This weekend I had a "Yeah Baby" moment.

I have been harping for a while that traffic on the IP network is about to suffer the fate of your typical Washington DC area commuter: gridlock at every corner, on your way to frustration station. If the on/off ramps and assorted intersections of the IP highway do not get some major upgrades soon, the traffic avalanche that is about to be unleashed will likely create disruptions that will bring front and center how the world's business has become dependent on this new type of "transportation".

The IP network is about as complex an ecosystem as they come, partly because there are so many disparate building blocks that maintaining compatibility is like putting together a puzzle where the shape of the image keeps changing. That's why after I read pages 64-73 of Infinera Corp. (INFN) S-1 filing I had a "deja-vu all over again" to when I read Cypress Semi (CY) vision for SunPower (SPWR). Infinera's Photonic Integrated Circuit (PIC) takes dozens of the small, tough to match, building blocks of the IP network and collapses them on one tiny, power / cost efficient, and smoothly working chip, the size of a baby's fingernail. Layer some sophisticated traffic-management-software on top of it, and this has all the makings of a disruptive technology emerging just at the right time.

But enough on the techno-babble. Minyans can save that for their own Saturday night excitement. Instead I'll offer my take on how the road from "Big Thing" to "Big Money" is haping up.

The Good

  • Revenues are ramping, and should continue to ramp very quickly as deferred revenue recognition contractual terms shrink from the 3-5 years time frame of older contracts, to the 1-year term of newer contracts. Estimates are for revenue growth of 24% Y/Y for '08 and '09.

  • The deferred revenue model, once it ramps, helps with forward visibility.

  • INFN's software is a critical component of its products, and software inherently carries much higher margins than just hardware.

  • Level 3 Communications (LVLT) business – which accounted for 55% of revenues at the end of 2Q '07 – probably carries somewhat lower margins, so new customers could further boost profitability.

  • 80-85% of revenues come from N. America. A weaker dollar should help expansion in yet untapped international markets.

  • Big loss NOL carry-forwards will allow for cash flow meaningfully higher than GAAP EPS once profitability ramps.

  • INFN has positive cash flow from operations in 2Q '07

  • INFN current PICs are first generation products, leaving plenty of room for improvements.

  • PIC's cost advantage may open broadband delivery to less densely populated areas, creating new revenue opportunities for MSO's and INFN.

  • There is a lot of competition in this space, but INFN controlled 30% of the market for 10 Gbps long-haul interface ports worldwide in 2006. Watch for Ciena (CIEN), JDS Uniphase (JDSU), Cisco (CSCO) and Huawei Tech. as they are key threats.

  • INFN has some smart cookies as its largest shareholders: VC backer Kleiner Perkins, Marsico Funds, and Gilbert Gagnon Howe.

  • Only underwriters Goldman Sachs (GS), Lehman Bros. (LEH), and Thomas Weisel cover the stock, leaving plenty of room for others to jump on the bandwagon.

The Bad

  • 55% of revenues came from LVLT at 6/07. That's a lot of eggs in one basket and INFN must continue adding new customers in order to succeed and improve margin opportunities.

  • INFN needs to grow quickly to justify its 5.5x Price/12 Months Forward Revenues.

  • The low number of customers makes INFN's business inherently lumpy quarter to quarter, which can create "disappointments" (or buying opportunities, depending on your outlook).

  • On an annual basis INFN awards stock options equivalent to approximately 5% of its outstanding shares. That's a lot of dilution especially for an unproven public company.

  • Recently there was a warranty reserves spike due to a product problem. That's not what you want to have as you start off as a public company looking to lasso new customers. It's important for this issue to go away quickly.

  • INFN's IPO cash is in short term investment grade instruments, and yet but its commercial paper suffered a $26k loss in 2Q '07. The amount is trivial, the fact that such a loss occurred in the first place is not.

  • There is pending IP litigation, always an unknown for tech companies.

To Watch

  • INFN had 31 customers as of 2Q 10-Q, after adding 21 new ones over the prior twelve months. This is a critical metric as it also likely impacts margins.

  • Hardware-only sales must be kept to a minimum as they carry little if any margins.

  • Deferred revenue model offers visibility, but also makes collection on revenues more important. Watch DSO's closely.

  • Latter dovetails with "customer acceptance period" which averaged 10 days in 2Q '07. Worth keeping an eye on as well.

  • Lock-up expiration arrives on December 3. See "who" sells, and how much of the 51 mln locked-up shares are sold.

  • Watching the ratios in the little spreadsheet below may come in handy to judge INFN progress.

Click to enlarge

In the company's own words "growth in invoiced shipments from 2006 and 2007 is due primarily to increased shipments to existing customers and the addition of a significant number of new customers. The growth in revenue reflects this increase in invoiced shipments and shortening of the average revenue recognition period." (Pg. 30 of the Q2 '07 10-Q for more details).

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Position in INFN, CIEN, CY
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