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After Derailment and a Leap of Faith, Infinera Is a Market Leader Again

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Infinera's decision to bypass an entire product cycle and bet the farm on the transition to 100 GB technology appears to be paying off.

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The "Razor / Blade" Model

Infinera's business is pretty much a straightforward "Razor/Blade" model. The company earns its footprint in carriers' networks by selling them DTN-X boxes with a starter amount of Tributary Access Modules (TAM) and Transport Line Cards (TLC). The boxes carry margins only in the mid-30%. The high profit stage of the business kicks in when, over time and as network's demand rises, the carriers fill in the boxes with high-margin (50-60%) TAMs and TLCs. The "fill in" cycle can last several years until a whole new generation of technology is ready for deployment. As a point of reference, INFN still draws a significant portion of its revenues from sales of 10 GB TAMs into the six-year-old DTN boxes.

It's fair to say that, if DTN-X box sales develop as suggested so far by the company, this product line is likely to have much better penetration and success than its 10 GB precursor.

Valuation

Counterintuitive as it may seem for a high technology company, I tend to approach INFN's stock as if it were a deep-cyclical. That means I want to buy the stock when it is very expensive and I want to sell it when its business reaches peak profitability and the stock appears inexpensive using various earnings measures. At the peak of the last cycle in Q2 of 2008, INFN traded at an EV/EBITDA of 10, on quarterly revenues of approximately $160 million and EBITDA of $45 million. If the business simply gets back to that kind of revenue run rate and profitability by 2015, the stock could reach the mid to high teens before then.

Also consider the following: 1) back in 2008 INFN relied on a single customer for almost 50% of its business. This time around the company has already sold boxes into 27 different customers, and CenturyLink was the largest customer at just above 10% of revenues; 2) widening its revenue base, and/or adding another high-profile tier 1 customer (Verizon (NYSE:VZ) tech folks have appeared with Infinera executives at several recent conferences) would meaningfully de-risk INFN's business and increase its valuation range; and 3) barring some other macro disaster, this product cycle could last well past 2015.

The Risks

The number of competitors in this space is limited primarily to CIEN and ALU. Infinera's management has made it very clear that the Chinese market is not open to foreign companies, in the same way that US the market is not totally open to China's Huawei for the same reason. But price competition between these few providers is fierce, especially when it comes to establishing the initial presence in the network.

Second, due to the limited number of buyers of this type of technology, orders can be very lumpy. Having followed INFN for several years my sense is that investors and traders understand this and do not overreact to quarterly misses or beats. That said, it makes it a lot harder to model numbers and valuation expectations.

Bottom Line

The first time around INFN's potential was stunted by the financial crisis, and its subsequent decision to bypass an entire product cycle and bet the farm on the transition to the 100 GB technology. By all indications the gamble appears to be paying off. INFN is rolling out a best-in-class solution, and barring another macro disaster the runway for INFN DTX-N boxes and blades should last several years. If INFN merely returns to the 2008 revenue and profit run rates, and its stock is given the same kind of valuation it garnered back then, there is 50 to 70% upside within the next 24 months. More blue chip customer wins and/or a higher multiple could reasonably push the stock back to its all-time high in the mid-$20s. I have a significant long position, which I hedge periodically with long-dated put options as insurance and for cash flow.

Twitter: @FZucchi
Position in INFN.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

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