I know it’s been a while since Saul owned Infinera, but I suspect some here are still interested.
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For Infinera investors, this quarter offered more tricks than treats, and guidance suggests a wintry mix when 4Q16 results are reported in February.
Earnings Report Highlights
The earnings press release can be found here: http://investors.infinera.com/new-releases/press-release-det…. Seeking Alpha’s transcript of the conference call can be found here: http://seekingalpha.com/article/4015514-infinera-infn-q3-201…. (Thanks, Seeking Alpha.) Unless stated otherwise, all italicized quotations are from the Seeking Alpha transcript.
3Q16 Revenue: $185.5 million This is a 20% decline from 3Q15. It looks even worse when you realize that the 3Q15 revenues included only a few weeks of Transmode revenue. That said, it is not as if this result was unexpected – management had guided towards $180-190 million. In terms of Wall Street expectations, I’m seeing very different numbers from Yahoo! Finance and Seeking Alpha. According to Yahoo!, Wall Street was exactly right, estimating $185.5 million. Seeking Alpha, though, describes the result as a $10.9 million miss.
In millions (GAAP).
1Q 2Q 3Q 4Q Comments
2012 104.7 93.5 112.2 128.0
2013 124.6 138.4 142.0 139.1
2014 142.8 165.4 173.6 186.3
2015 186.9 207.3 232.5 260.0 3Q15 Transmode acq.
2016 244.8 258.8 185.5
3Q16 Gross Margin: 45.6% GAAP and 49.2% non-GAAP Management had guided for non-GAAP gross margins of 45-49%. At the risk of sounding like a fanboy, I think these margins show that Infinera remained disciplined on selling price despite a difficult sales environment, especially in Metro. Admittedly, though, there were other – more ephemeral – factors such as product mix and some one-time factors.
3Q16 Operating Margin: -5.9% GAAP and 3.6% non-GAAP Guidance had been for non-GAAP operating margin between -2% and +2%, so management beat the top end of guidance.
3Q16 Net Income: GAAP $-11.2 million ($-0.08 per diluted share) and non-GAAP $7.4 million ($0.05 per diluted share) Management’s guidance for non-GAAP earnings per share was a range from $-0.02 to $0.02. Again, Wall Street expectations diverged, depending on source. Yahoo! Finance seemed to imply that Wall Street expected breakeven results for non-GAAP earnings, but Seeking Alpha says results exceeded expectations by $0.12.
Earnings per Share (GAAP)
1Q 2Q 3Q 4Q Comments
2012 -0.19 -0.27 -0.17 -0.14
2013 -0.13 -0.09 0.03 -0.08
2014 -0.04 0.04 0.04 0.06
2015 0.09 0.13 0.06 0.08
2016 0.08 0.08 -0.08
Earnings per Share (non-GAAP)
1Q 2Q 3Q 4Q Comments
2012 -0.07 -0.05
2013 -0.06 -0.01 0.10 -0.00
2014 0.03 0.11 0.11 0.13
2015 0.16 0.18 0.22 0.21
2016 0.19 0.22 0.05
3Q16 Cash Flow From Operations (CFFO): $5.2 million; CapEx: $9.6 million. This is a pretty anemic CFFO number, and the larger CapEx number (although a decline from last quarter) means that free cash flow was negative. I’ll examine this briefly in a separate section.
4Q16 Guidance
Revenue: $165-185 million (vs. $260.0 million in 4Q15; a wider range than normal)
Non-GAAP Gross Margin: 40-42% (vs. 48.3% in 4Q15)
Non-GAAP Operating Expenses: $88-92 million (vs. $92.8 million in 4Q15)
Non-GAAP operating margin: -10% at the midpoint (vs. 12.7% in 4Q15)
Non-GAAP earnings per share: $(0.16)-(0.12) (vs. $0.21 in 4Q15)
GAAP earnings per share: $0.13 less than non-GAAP earnings per share
Per Yahoo! Finance, Wall Street had previously expected 4Q16 revenues of $197.5 million and $0.01 in non-GAAP earnings. I described last quarter’s guidance as “an extraordinarily negative surprise”, given an $88 million revenue miss and a $0.22 non-GAAP earnings miss. This quarter’s $22 million revenue miss and $0.15 non-GAAP earnings miss is not quite as bad, but is still quite large and about as unwelcome as teenagers bearing eggs on Halloween.
INFN earnings day share price: $7.935 -14.03% (vs. S&P 500 -0.30%) My tendency is to believe Yahoo!’s version of Wall Street expectations, which indicated basically in-line results. I lay the blame for the share price decline on the weaker-than-expected guidance.
Customer Discussion
Chief Financial Officer (CFO) Brad Feller didn’t speak to the Cloud Xpress customer count. That could mean that the count remains unchanged at 27 or that Infinera no longer looks at CX as a new product and has stopped reporting changes to the customer count.
CEO Fallon disclosed that two customers have purchased the new Xceed Software Suite, which I’ll discuss later. Presumably, these are both pre-existing customers – one certainly is.
There were two 10% customers for the quarter: a Tier-1, and a wholesale and enterprise carrier.
Long-haul (and Subsea)
Early in his prepared remarks, Chief Executive Officer (CEO) Tom Fallon blamed the current challenges the company is facing on “… not yet being a sufficiently diversified business …”. During the Q&A session, he expounded on this point, highlighting both a geographical component (too concentrated in North America), as well as a market component (too concentrated in long-haul). The company has taken steps to improve these concentrations. Cloud Xpress opened the DCI market for Infinera, but it is still too small to overcome the impact of the long-haul slowdown. The acquisition of Transmode simultaneously offered a solid beachfront in Europe and a small market share in the Metro space. Infinera seems to be working with partners in other geographies, rather than trying to establish their own international sales force from scratch. Recent successes in Latin America were specifically cited.
Industry analysts predict a 5% compound annual growth rate (CAGR) in long-haul between 2016 and 2020. One issue with this estimate is that it is across all geographies, and much of this year’s growth has been in China, a market that Infinera doesn’t serve. Infinera may never penetrate China due to government protectionism of local manufacturers.
Further, the year-end dynamic in the long-haul space seems to be tighter than in recent years. According to CEO Fallon, “… several of our largest customers have already ordered up to their annual CapEx allocations, hence we are not planning for any benefit from year-end money in Q4 and are seeing certain opportunities pushed into next year.” In past years, these customers may have been allowed to go over budget when network capacity was strained, but this year it seems that the purse-strings are tightly-held.
Regarding when we can expect a recovery, CEO Fallon says, “Restoring our long-haul business will take some time … we are starting to have visibility into several new footprint opportunities over the next few quarters and expect capacity fill activity, which is currently lower than typical, to also recover in 2017. … my expectation is that current softness in long haul will subside in 2017 and the long haul market will resume growing at a mid single-digit level.”
CEO Fallon talks about 2017, but can we expect early relief? I get the impression that there may be some, but not a lot. Q1 for Infinera is typically a time when customers are still finalizing their budgets. Seasonally, it is often the weakest quarter of the year, with the second quarter being the second-weakest. Often, purchases by the cable companies are front-loaded in the calendar year, but CFO Feller cautions that this year could be different due to acquisitions among Infinera’s major cable customers. In cases where network constraints have become unbearable because of spending that didn’t occur in late 2016, there might be some relief in 1Q17.
It would also not surprise me if customers are waiting for Gen4 – the Infinite Capacity Engine (ICE) – to be embedded in Infinera’s long-haul products. We don’t know the precise timetable for that yet, but I’m pretty sure it will be revealed at the Insight Infinera event on November 17. I’m also pretty sure that the subsea market has dried up for Infinera until ICE-enabled products are available.
My impression is that we may have to batten down the hatches for several quarters.
Data Center Interconnect
CEO Fallon described DCI as “… a bright spot and an outstanding growth opportunity …”. Industry analyst ACG describes the whole market as growing at a 29% CAGR through 2020, but they also note that the purpose-built, small form factor subset of the DCI market (where Infinera plays) is likely to grow at a 57% CAGR to become a $2 billion market by the end of the decade.
Infinera currently has a 94% market share of this subset of DCI. Furthermore, it is jealously clinging to that market share by making Cloud Express 2 the first product to embed the Gen4 ICE photonic integrated circuits (PICs). Initial shipments are expected in 1Q17. Infinera disclosed record DCI revenues in 1Q16 and then again in 2Q16, but “… DCI revenue was down sequentially in Q3 though we see a strong pipeline building for the rest of the year and into FY 2017.”
Metro Core, Aggregation, and Access, and Mobile Front-haul and Back-haul
The news hasn’t changed much for Infinera in the Metro space. Adoption is still “… taking longer than expected…”, although Infinera is closing some smaller deals. Although the opportunity in mobile front-haul and back-haul is enticing, the main target customers for Infinera are the domestic Tier-1 carriers, a group Infinera has not penetrated well in the long-haul space. There were some international Tier-1 front-haul wins touted in Infinera press releases a few months ago, but co-founder and company President, Dave Welch, cautions us that such initial deployments are typically slow to progress into larger revenue volumes. It is possible that Tier-1 carriers may be more receptive to Infinera now that they are capable of providing an end-to-end solution (especially an ICE-enabled one), but it will certainly be the case that entrenched providers to these carriers will fight tooth and nail to keep the business.
Industry analysts continue to expect Metro to grow faster than long-haul in the coming years, predicting 8% growth through 2020. I’m really eager to see how and where Gen4 impacts Infinera’s Metro products when details are unveiled at Insight Infinera.
Software
With the introduction of the Xceed Software Suite, Infinera has taken the leap from having features that support software-defined networking (SDN) to products that support SDN. SDN could be especially potent for both carriers and Infinera, due to automated enabling of slices of Infinera’s Instant Bandwidth as traffic demands and budgets allow.
I mentioned earlier that there are currently two customers who purchased the Xceed software. One of them is using it across both TM (Transmode Metro) and DTN-X (Infinera long-haul) equipment.
Infinera’s Operating Expense Management Revisited
Two quarters ago I did a bit of a deep dive into operating expenses, and I updated the numbers last quarter. I want to make sure that we stay on top of these numbers, especially while revenues are depressed. You may recall that last quarter I suggested that what we might see is a decline in expenses in absolute terms, but an increase in these expenses as a percentage of revenue, due to the precipitous decline in revenue. That prediction has proven accurate for all three operating expense lines between Q2 and Q3. First, CEO Fallon has long talked about reining in R&D at 20% of revenue. This quarter, R&D was 27.4% of revenue. I’m not upset about this right now, although my concern will increase if it continues trending above 25% well into the future. Right now, the company needs to roll out its Gen4 products quickly, and make sure the delay between Gen4 and Gen5 is shorter than between Gen3 and Gen4. Now is not the time to constrain R&D spending. R&D is a technology company’s life blood, so I wouldn’t be opposed to CEO Fallon upping the percentage from 20% to 25%. That said, if R&D stays much above 25% for extended periods, that adds another hurdle to GAAP profitability on top of the already difficult hurdle presented by the company’s vertical integration, of which I’ve spoken at length in past posts. For now, let’s keep watching the trends. Sales and marketing had been around 12.5-13.0% of revenues, and it jumped to 15% this quarter, although the dollar amount declined from Q2. General and administrative had been around 6.5-7.0% of sales. This quarter it rose to 9% of sales, despite declining in absolute terms.
Infinera’s Weak Cash Flow This Quarter
I took a look at the statement of cash flows and highlighted a few items for further research. Fortunately, CFO Feller touched on all of them in this comment from his prepared remarks: “… working capital changes negatively impacted cash flows in the quarter, as we increased inventory due to Gen 4 PICs transitioning into production and our taking longer-term positions on certain external components that are in high demand. This use of cash, along with declines in AP and deferred revenue, more than offset our AR decline, which occurred as a result of the lower revenue levels.” Changes in inventory was the biggest component, and it is good to hear that a large portion of them are Gen4 PICs – that’s not the kind of component I’m worried about being written down due to lack of demand. I’ll try to circle back to Infinera to find more details about inventory composition when they eventually file their quarterly report on Form 10Q with the SEC. Back to CFO Feller’s comments, for those less familiar with accounting, AP means accounts payable (bills Infinera have received but haven’t paid yet) and AR means accounts receivable (bills Infinera have sent to customers but for which payments haven’t yet been received). Fluctuations in AR and AP are pretty normal, but it is good to keep an eye on them. Surprise increases in AR could mean customers are unwilling to pay Infinera, while increases in AP could indicate liquidity issues at Infinera. What I see currently looks like normal fluctuations and not anything concerning. Speaking of inventory…
Aggressive Pricing. Temporary?
Aggressive pricing was mentioned many times in the conference call, mostly during the Q&A. Coupled with the prediction of lower gross margins, I started to be a bit concerned. As I studied the conference call transcript – and Infinera’s situation – a bit more deeply, I became less concerned. I suspect that Infinera will have to price its Metro products a little more aggressively than it would like to, in order to gain market share. That is a situation that will probably persist for many quarters. But I do think we have a short-term issue where more broad-based aggressive pricing makes sense. We are currently in a period where Gen4 has been announced, but is not yet shipping. I greatly doubt that Infinera has sold all the Gen3 inventory that it had built to support “Time as a Weapon”. If not sold soon, much of that inventory will likely have to be written down or written off. On the one hand, Infinera doesn’t want to cheapen its brand too much by giving product away. On the other hand, especially in the Metro space, Infinera is hoping new customers will try their product and like it, so they can gain a foothold in that company’s network. Aggressive pricing could persuade some of those potential customers to make a purchase. I doubt any aggressive pricing of this nature will persist past 1Q17 or thereabouts. Once the Gen4 Infinite Capacity Engine is available, I’m pretty sure Infinera believes that its features and capacity will make discounting unnecessary.
Infinera’s Weak Guidance This Quarter
Regarding anticipated 4Q16 revenues, CFO Feller cited some of the same issues raised in my quotes from CEO Fallon earlier: several customers are already over their CapEx budgets. He also noted limited visibility into customer “fills” (i.e., adding additional bandwidth to an existing chassis, or requesting an additional slice be activated in an Instant Bandwidth module). On the expense side, CFO Feller noted attempts to control costs during this time of diminished revenue, specifically mentioning a hiring freeze. But he also explained that Infinera’s 4Q16 has an extra week compared to 3Q16 or 4Q15, allowing more costs to accumulate and making comparisons more difficult.
Other Random Musings
Oops… My Bad…
CEO Fallon indicated that he feels he made a mistake a few years ago, and that is what has delayed the delivery of the Gen4 ICE technology. He didn’t offer any more detail about it, but it is not a point that he necessarily had to disclose to answer the analyst’s question (“… what gets the business back to a recovery mode?”) I’ve said this before, and it remains true: CEO Fallon is transparent to a fault, and took responsibility for his mistake. I talk about “tricks” and “treats” in this post, but I’m just trying to inject seasonal humor. I don’t believe Infinera management is trying to “trick” anyone in any real sense. If anyone got that impression, then “Oops… My bad…”!
Underlying Demand for Capacity – Plus Having a Great Product – Will Win
CEO Fallon summed up his view of the big picture nicely: “… the long haul will continue to grow in the mid-single digit range over the next several years. I don’t see any abatement of fundamental demand, of fundamental traffic. Quarter perturbations, and I do believe that we are being hit in Q4 by CapEx limitations by some of our biggest customers. That doesn’t alter the fact that they need more capacity. And so far, we continue to be their provider of infrastructure and I’m anticipating next year that that recovers. I believe that when we get our next-generation platform out, that will help us tremendously.”
Most Amusing Quotes from the Conference Call
“Dmitry G. Netis - William Blair & Co. LLC
… I’ll ask a simple one on the Gen 4 first. I think you guys said Q1, can we expect that in January, March, February, month? Any more quality on that would be good.
David F. Welch - Infinera Corp.
Are you placing a purchase order? What’s the…
Dmitry G. Netis - William Blair & Co. LLC
Let’s assume I am.
Thomas J. Fallon - Infinera Corp.
How many do you want, Dmitry?
David F. Welch - Infinera Corp.
Yeah, how many do you want? We’ll move you up in line.”
Concluding Remarks
Last quarter, I described it as “a very frustrating time to be an Infinera shareholder”. Although this quarter’s post-earnings share price action pales in comparison with the 33% drop we were “treated” to last quarter, I think the frustrating times remain with us, and the forecast is for more of the same in the near term. Last quarter, I knew that the Gen4 release schedule would be unveiled at Insight Infinera, so I held out some hope for the fourth quarter based on an assumption that Insight Infinera would be held in September, as it always had been since I started to cover the company (not THAT long ago). I made a bad assumption, but it sounds as if many customers wouldn’t have been able to react to fourth quarter availability anyway due to CapEx budget constraints. At this point, I think all we can really do is wait a few weeks for Insight Infinera and hope that the announcements offered there make us as thankful as we should be in late November.
Fool on!
Thanks and best wishes,
TMFDatabaseBob (long: INFN)
See my holdings here: http://my.fool.com/profile/TMFDatabasebob/info.aspx
Peace on Earth
Please note: I am not a member of any newsletter team. My opinions are my own. I want to share my research with you since we’re all part of the larger TMF Community.