Goldman upgrades INFN to neutral

Goldman upgrades their position to neutral and removes INFN from their conviction sell list. They maintain a $16 PT.

As of this update, there are now no sell recs on INFN from any of the sell-side analysts.

Here was Goldman’s rational for the upgrade:

http://www.benzinga.com/analyst-ratings/analyst-color/16/04/…

“Our Sell thesis was based on our view that Infinera’s premium valuation was not reflective of mid-term risks such a choppy end market and rising competition,” analyst Doug Clark wrote. He added that there was now limited downside risk, with shares trading broadly in-line with historical valuations.

Limited Downside To Estimates

The company’s addressable market has expanded 100 percent, with M&A and new product launches. Clark commented that the company was getting “closer to realizing the synergies and market share gains of these efforts.”

The analyst expressed optimism regarding Infinera achieving gross margin expansion, backed by a favorable mix shift to high margin line card sales and Instant Bandwidth.

Translation: Now that all of our institutional clients were able to get their shares in on the cheap, we’re ready to let the stock continue its course.

Doug Clark cites mid-term risks such as “choppy market” and “increasing competition” as the reason for their sell recommendation, yet, Infinera has beat every single one of the earnings estimates since that sell recommendation came out. It would look mighty silly if Doug Clark continued with his sell recommendation on top of another quarterly earnings beat. That’s my 2c of course.

Best,
–Kevin

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Dear Kevin, you sweetheart of a human, you:

Monkey has been following your stupendously useful, thorough and easy to read and understand in-depth analysis of Infinera with so much joy that sometimes he forgets to eat his breakfast banana. So the bull case for Infinera is 100% documented and understood, even by a cognitive simpleton as yours truly.

But Monkey doesn’t quite have the brain to understand why the market is still extremely timid––to say the least––with what seems like inevitable growth in this industry, with Infinera leading the way. The stock, too, is still down 40% from its highs, despite everything we know about Infinera’s winning of customers and expanding into exponentially growing markets.

Obviously Monkey’s question is Why Why Why Why?

  1. Is it that the technology is hard to understand and so the pessimists want proof of large revenue increase first?

  2. Is it because all technologies eventually get left behind by something better?

  3. Is it the misunderstanding of whatever it is Microsoft is up to, even though that was explicitly addressed by Infinera as a non-issue?

  4. Is it because Infinera has been at this a long time and even though it’s got really smart people and a really smart team, it’s been one delay after another after another with new hurdles each and every time pushing the bananas just out of reach quarter after quarter?

  5. Or what? Because right now Monkey is starting to really think INFN might be offering the best risk/reward ratio in the entire jungle. Help temper my enthusiasm a bit, please.

By the way, on a scale of 1 to Bananas, how much personal conviction do you have, Kevin, in INFN the stock? And if you don’t mind me asking, what percentage allocation do you have in it?

So yeah—Monkey likes to think the market isn’t being deliberately stupid––after all, everybody likes bananas. And it’s poor form for Monkey to think he’s smarter than everyone else: that’s the job for humans. So what’s he missing? Why is there only a metaphorical upgrade to “neutral” given what we know?

Thoughts?

Humbly Yours,

Monkey
Long INFN since 2009

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Monkey - I have a theory on this.

A few years back Infinera issued a convertible bond offering. A convertible bond behaves both like a bond and a stock - in that the bond can be converted into shares at some point before the bond matures. In the meantime, the purchaser continues to receive interest on the coupon. It was sold at 1.75%.

Hedge funds are the typical purchasers of these types of assets. And when they purchase them, they also sell the security short as a form of a hedge.

https://en.wikipedia.org/wiki/Convertible_arbitrage

Convertible arbitrage is a market-neutral investment strategy often employed by hedge funds. It involves the simultaneous purchase of convertible securities and the short sale of the same issuer’s common stock.

The premise of the strategy is that the convertible is sometimes priced inefficiently relative to the underlying stock, for reasons that range from illiquidity to market psychology. In particular, the equity option embedded in the convertible bond may be a source of cheap volatility, which convertible arbitrageurs can then exploit.

Here is some info on the nature of the bond Infinera has issued:

http://seekingalpha.com/article/3657966-long-infinera-radar-…

Infinera has a capital structure that includes only one bond - A $150 million 1.75% convertible bond with maturity in 2018 and a conversion price of $12.58 per share. This means that at any point in time, Infinera might have no interest expense (by converting the bond into stock) and add a little dilution to its equity float. Dilution would be approximately 11.9 million shares, or 8.5% of total shares outstanding as of last quarter.

This bond was issued as a private placement, and the fact that the bondholders have not yet converted their bonds to realize the gains sends a behavioral signal to the equity market. Assuming bondholders know what they are doing, it appears that they continue to see upside potential in Infinera’s stock. At this point, the intrinsic value of the call options embedded in the bonds is approximately $88.5 million. Small and cheap debt makes Infinera carry very little financial risk, tilting the risk and reward in favor of equity investors because most of the earnings accrue directly to shareholders.

Who owns these bonds currently? http://stockzoa.com/cusip/45667gab9/

Hence, as a result of the hedge fund strategy you have the same institution both long and short - and that is ok for them as long as they are still north of the issuance price AND they continue to receive 1.75% interest. These institutions are long term bullish, but hedging over the short term. And consequently, you have a short interest on the stock which may spook your average investor into having some jitters about the direction the stock is heading.

That’s my attempt at an explanation, although I can’t be certain that is the 100% reason either. Keep in mind, too, that not everyone in the world reads these boards, and, although Infinera is well understood here - it likely isn’t very well understood outside of our little oasis.

Hope that helps some.

Best,
–Kevin

20 Likes

"By the way, on a scale of 1 to Bananas, how much personal conviction do you have, Kevin, in INFN the stock? And if you don’t mind me asking, what percentage allocation do you have in it? "

Monkey asked the questions in quotes above; Kevin, did you answer these questions? I apologize if you did but I did not see it. I, too, am interested in the answers.

Best,
az5speedy

Hence, as a result of the hedge fund strategy you have the same institution both long and short - and that is ok for them as long as they are still north of the issuance price AND they continue to receive 1.75% interest. These institutions are long term bullish, but hedging over the short term. And consequently, you have a short interest on the stock which may spook your average investor into having some jitters about the direction the stock is heading.

Yet, a constant short position would not be affecting the stock right now, nor last month nor the month before. Seems like they might have taken that short a few years back if it was a long term arbitrage. I suppose you could say they didn’t short back then, but once the price got into the 20’s it was just too tempting and they were really smart and shorted last August. If they did, then they were still done with it and should not be affecting price now, in fact, they might be holding a high profit on the short and want to close it out for another opportunity later.

Maybe the market just hates seeing a PE of 42 on Yahoo and feels it had a great run and the mo-mo funds moved elsewhere and maybe another earnings beat starts to knock some sense into them.

However you measure the market, we have had a nice long run and “smart” investors are rotating out of high growth stocks. We will make our money in the long term if we are right.

P.

Kevin:
I very much appreciate your work regarding INFN, as I think we all do around here. Your enthusiasm for the company certainly comes thru loud and clear.

I have always thought INFN would be a long-term winner, ever since the days when MF first recommended it. And why not love the prospects: so much more data is being consumed via the internet, ALL users will need faster speeds and bigger data pipes in order to get reasonable performance. Every time I hear about exploding Netflix use, or Facebook rolling out their VR gear, I am again reminded how much more will be needed in the future.

I too am interested in your commitment level, as I wonder: should I have more in INFN!
It is my biggest holding, but I still wonder if it has the greatest potential.

I don’t mind sharing some of my top holdings, as I think they all still have good prospects:

Vanguard Mutual Funds - 33.1%
Infinera Corp. - 6.3%
Markel Corporation - 4.4%
IPG Photonics Corporation - 3.3%
Apple Inc. - 3.2%
Facebook Inc - 2.8%

Thanks again for your great work,
Jon

2 Likes

Pete, I think you actually hit the nail on the head, in my opinion:

I suppose you could say they didn’t short back then, but once the price got into the 20’s it was just too tempting and they were really smart and shorted last August. If they did, then they were still done with it and should not be affecting price now, in fact, they might be holding a high profit on the short and want to close it out for another opportunity later.

If you scan that list of bondholders you’ll see a familiar face: Goldman Sachs.

Far be it from me to accuse a wall street organization guilty of market manipulation - but I don’t think it would be too far of a stretch to follow a path of
1) short the stock at its high
2) issue a sell recommendation on the security, so that I can
3) repurchase the security at a much lower price.

The beauty of this strategy is I have a built-in lock in protecting my short - through the convertible bond I own the equivalent of a long term 2018 call with a 12.58 strike price - and I can cover my short easily if the stock really did run away from me by converting the bond to shares.

Again, just my 2c.

Best,
–Kevin

2 Likes

Jon,

I too am interested in your commitment level, as I wonder: should I have more in INFN!

I think what concerns me most with a disclosure is we all have to decide for ourselves on a comfortable allocation. Just like Saul says to us - don’t follow me into the positions just because I’m in them.

How much you have allocated depends on a lot of things, like

  1. are you comfortable holding an investment over a longer term period?
  2. are you comfortable with a security’s volatility? what is your risk appetite?
  3. how close are you to retirement?

Those are the types of things you need to factor in when making decisions on allocation. I hesitate to share mine because I don’t want what I do to be the influence on buying more shares without reviewing their list of 1,2,3’s.

How about we leave it at this: I have position that is commensurate with my own personal 1,2,3’s, and yes, I have a high amount of conviction on Infinera’s future - but you probably knew that last part already.

Best,
–Kevin

18 Likes

Here’s my $0.02 on the difficulties that INFN stock has had over the past 12 months. (And these thoughts are worth exactly what you paid for them!) Let’s look at the types of shareholders that likely make up INFN’s ownership base:

Convert holders: The convertible bond issue matters, but isn’t the driving force IMO. The variance in number of shorts outstanding is not material enough to be a big factor in a price move from over $25 down to under $15 for a stock that has good average daily volume like INFN. The mindset laid out by Kevin for the convert holders is spot on, but when compared to average daily volume the impact of this just isn’t big enough. Shares short have moved from ~12M near the share price peak in summer 2015 to a high of just over 15M in fall 2015 to 11.2M now. Not a big deal for a stock with 141M shares outstanding and average daily volume around 2M. So for sake of argument, let’s call this a minor negative.

Transmode Legacy holders: Another cohort would be those that were given shares of INFN as part of the Transmode buyout. I believe that a significant number of these investors are unwilling/unable to hold shares of a foreign company. Even if this is not the case, history has shown repeatedly that a high percentage of shareholders will liquidate shares they receive as part of a spinoff/buyout/corporate event (there is a subset of investing strategies dedicated to just this phenomenon to take advantage of this tendency). So let’s mark that as another small negative since the summer 2015 peak.

Stodgy Wall Street: Yet another factor is the ‘slowness’ with which a company like this is viewed by big ‘fundamental’ money. Networking component suppliers have traditionally been a really terrible business unless you are massive enough (CSCO) to push back against your customers. The changing composition of the buyer of INFN equipment is still a newish development, and traditional relative valuation metrics point to a company that was trading at an ‘inflated’ price relative to things like GAAP earnings measures. (Not that I agree with that sentiment, but that is how the big boys that apply Graham/Dodd/Buffet/et al see it). So you have a subset of the market that sees what they believe to be an overvalued cyclical stock. The ownership trend for institutions, while slightly rising over the past two years, has basically flatlined recently on a net basis. For mutual funds, the story is similar. Of mutual fund companies, only Fidelity has a material ownership of INFN (around 11.7% of outstanding shares) in a non-indexed fund through the Fidelity Growth Company fund. Total mutual fund ownership for INFN is around 42.5% of shares. Compare that to CIEN, with around 59.2% of shares held by mutual funds and a somewhat broader mix of active strategies listed as major holders (although nobody with a high level of conviction like Fidelity Growth Company and INFN). Room for more uptake for INFN.

Even for those that like the story and see the writing on the wall in terms of the massive opportunity set, INFN has a series of non-insignificant challenges ahead. INFN is a small company, and they will now have to juggle: 1) a significant acquisition, 2) multiple product launches, 3) ramping up R&D as per their re-commitment, 4) building relationships with a new set of customers as the opportunity set grows. I can tell you that institutional managers would rather wait to see a ‘clear winner’ in the space before plunking down money on what they may see as a ‘good story’ – good stories get managers fired when they underperform. In my opinion, the fact that INFN is STILL under the radar is a good thing, but for the past several quarters, let’s call this another negative.

Momentum guys and chartists: Another subset of buyers in recent quarters can be labelled as the technical analysis (chart reading) crowd. A large number of this group are ‘momentum’ traders, which in my opinion saw a great looking chart in October 2014 that was breaking out to the upside – those traders jumped on for as long as the chart pattern was constructive, but when the first signs of waning momentum popped up in summer 2015 (Transmode shareholders selling, etc.) these holders jumped ship at various points along the way. You can see from a longer-term chart that INFN sold off perfectly at various common TA selling points through the fall and into 2016. So this is yet another subset of former INFN shareholders that were in ‘outflow mode’. Another mark for the negative pile.

When you combine the impacts of each of these groups, I believe it paints a better picture of why INFN has been under pressure in recent quarters despite a strong series of earnings reports, exciting product launches, and the undeniable hype around metro/DCI.

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