INFN: gross margin and operating margin

INFN has a gross margin of about 45.5% (FY2015) and Fallon has stated that they want to be a 50% gross margin company. This means that the costs to produce the stuff that INFN sells is about half the price that they pay. For those of you who are not expects at looking at income statements, gross margin does not consider operating expenses (OpEx): R&D, Sales and Marketing, and General and Administrative. What is left over after subtracting operating costs is the gross profit (taxes, depreciation, and amortization are not yet considered). INFN’s operating costs are about 38.8% (FY2015) leaving INFN about 6.7% of the revenue as gross profit. This is the GAAP operating margin. After adjustments the non-GAAP operating margin for 2015 was 13.1%. Fallon has a target of 15% for non-GAAP operating margin.

So according to Fallon, INFN is heading toward a gross profit of 15%, or, in other words, INFN will eventually make 15 cents on every dollar of revenue.

Let’s compare this with SWKS. SWKS’s gross margin has been rising. In the June 2014 quarter SWKS had a gross margin of 45.4%, about where INFN was in FY2015. SWKS has been growing its higher margin business and reducing the contribution of its lower margin products (components versus integrated solutions). The new business has margins of about 55%. SWKS has also been leveraging its growth which means that the operating expenses rise more slowing on a percentage basis than the revenue. The business is scaling and the effect is a higher operating margin. In the December 2015 quarter SWKS’s operating margin hit 39.6%! This means that SWKS gross profit is 39.6 cents for every dollar of revenue. By comparison a current 39.6% operating margin for SWKS versus a 13.1% operating margin for INFN is a dramatic difference. SWKS is a more mature company and INFN is still scaling; however, why are INFN’s targets for eventual operating margin only 15%???

What we care about as investors is the per share earnings. So INFN will make 15 cents (before taxes, amortization, and depreciation) per dollar of revenue and SWKS will make about 40 cents per dollar of revenue. The next question is how fast is revenue growing. If INFN can grow revenue 3 times as fast as SWKS then INFN can grow EPS faster then SWKS despite a lower operating profit percentage. But this has not been happening. In FY2015, INFN grew revenue 32.9%. During the same time period, SWKS grew revenue 30.4%. So the 2 companies grew revenue at a similar pace, but we as shareholders kept A LOT more from SWKS than we did from INFN. The next question is what will happen in the future. We’ve been told by the management teams that we can eventually expect 15% operating margins from INFN and 40% from SWKS. If revenue for the 2 companies grow at similar rates in the future then SWKS is a far better investment. INFN would need to grow revenue about 3x as fast as SWKS to make INFN a better investment. Your job is to try to predict what will happen. Can these business grow revenue fast and so their products offer enough differentiation or stickiness such that margins can be maintained (competition can force companies to lower pricing which impacts margins while product/service differentiation can allow companies to keep their prices stable or even increase them).

Chris

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Note that my last post did not consider the stock prices of these companies and any under- or over-valuation would also affect how good of an investment each of these companies is. SWKS has a TTM P/E of 12.6 and INFN has a TTM P/E of 19.1.

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Chris another post that shows why you are one of my favorite Fools.

One point you did not make that should be brought up is, management can say anything. But Swks also has a history of performance. I just don’t want newer investors to believe every management that says “we are going to double revenue and earnings every six months” or whatever. Plenty of managements lie, plenty of managements are overly optimistic.

I can’t resist every now and again giving a big red thumb in CAPS to some of the frauds out there. There are plenty on any given day.

With respect,
Flygal
Long Swks

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Chris,

INFN would need to grow revenue about 3x as fast as SWKS to make INFN a better investment.

This is incorrect.

Let’s say a company has 2015 sales of 1B and net income of 150M. (15% net margin – I’m using that instead of operating margin, but the basics will hold true.)

This company grows sales 20% in 2016. Sales are 1.2B and the same 15% margin gives them 180M of net income.

If the P/E doesn’t change, let’s say it’s 15, the stock moves from 2.25B market cap to 2.7B market cap. Therefore stock gains 20%.

Let’s say another company has 2015 sales of 1B and net income of 350M. (35% net margin)

This company also grows sales 20% in 2016. Sales are 1.2B and the same 35% margin gives them 420M of net income.

If the P/E doesn’t change, let’s say it’s 15, the stock moves from 5.25B market cap to 6.3B market cap. Therefore stock gains 20%.

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PS - someone might argue that the difference in operating margins for SWKS and INFN indicate that INFN has more opportunity to grow margin, and SWKS has more risk that margins will contract.

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Chris - I just posted a thread on Instant Bandwidth.

I would love help quantifying this into dollars and cents. I believe Instant Bandwidth is something that will kick in more into the future than it does today, although I think today it can be used as a differentiator in a selling situation.

As I noted in the other post, Instant Bandwidth is 100% pure profit. I believe it has the potential to raise margins even further in the future.

What do you think?

Best,
–Kevin

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Chris - I just posted a thread on Instant Bandwidth.

I would love help quantifying this into dollars and cents. I believe Instant Bandwidth is something that will kick in more into the future than it does today, although I think today it can be used as a differentiator in a selling situation.

As I noted in the other post, Instant Bandwidth is 100% pure profit. I believe it has the potential to raise margins even further in the future.

What do you think?

Kevin,

I too tend to think that this will be a good differentiator. It will reduce INFN’s customers’ cost to add bandwidth. It will also reduce INFN’s customers’ time to add bandwidth which can help the customer’s competitiveness in the market and its revenue and profits.

So here are some things to consider:

  1. Will INFN’s competitors be able to offer something similar? If so when? Once competitors offer it too then it’s no longer a differentiator.

  2. What is the cost to INFN to “give” the their customer all these latent 100G components? Are they charging the customers something for this or do they only charge the customer when the bandwidth is activated? There has to be some extra cost to INFN for supplying equipment that can be activated in the future. What is this cost? Is INFN passing on this cost when the equipment is installed or when it’s activated, or some combo of the two? Maybe when the customer activates extra bandwidth, it’s not pure profit???

Chris

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This is incorrect.

Let’s say a company has 2015 sales of 1B and net income of 150M. (15% net margin – I’m using that instead of operating margin, but the basics will hold true.)

This company grows sales 20% in 2016. Sales are 1.2B and the same 15% margin gives them 180M of net income.

If the P/E doesn’t change, let’s say it’s 15, the stock moves from 2.25B market cap to 2.7B market cap. Therefore stock gains 20%.

Let’s say another company has 2015 sales of 1B and net income of 350M. (35% net margin)

This company also grows sales 20% in 2016. Sales are 1.2B and the same 35% margin gives them 420M of net income.

If the P/E doesn’t change, let’s say it’s 15, the stock moves from 5.25B market cap to 6.3B market cap. Therefore stock gains 20%.

Paul, yes, my statement might be incorrect because it didn’t consider the price of the stock (company). We don’t know what P/E the market will assign to these companies in the future. My main point is to consider that as a business, it is important to consider the margins. Fallon has said that they want to get to 15% operating margins. To me this seems too low when there are gross margins of around 50%. Why is INFN not setting its sights higher? Is this business not able to get operating leverage like SWKS did? One would think that as revenue grows the percentage of OpEx line items would be able to decrease.

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PS - someone might argue that the difference in operating margins for SWKS and INFN indicate that INFN has more opportunity to grow margin, and SWKS has more risk that margins will contract.

Conversely, one could argue the INFN is a lot closer to being unprofitable than SWKS.

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Chris,

1) Will INFN’s competitors be able to offer something similar? If so when? Once competitors offer it too then it’s no longer a differentiator.

The only way a competitor to match the differentiation here is to start building PICs themselves. Infinera will be able to get up to 2.4TB per PIC - pre-provisioned - while the closest neighbor is only just approaching 500GB.

2) What is the cost to INFN to “give” the their customer all these latent 100G components? Are they charging the customers something for this or do they only charge the customer when the bandwidth is activated? There has to be some extra cost to INFN for supplying equipment that can be activated in the future. What is this cost? Is INFN passing on this cost when the equipment is installed or when it’s activated, or some combo of the two? Maybe when the customer activates extra bandwidth, it’s not pure profit???

There are no extra components in their model. Everything is built onto the PIC. It is a monolithic design. As such, they don’t have extra costs associated in dealing with component manufacturers.

Their costs are largely controlled by the fact that they own their own process. None of the other system vendors do.

Literally, there is only one base cost for the PIC - no matter if 100GB or 2.4TB is provisioned on it. It has that much capacity.

So, when the customer turns on an additional 100GB - it is already there waiting to be turned on. There are no additional costs here. It is 100% profit.

Does that help?

Best,
–Kevin

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There are no extra components in their model. Everything is built onto the PIC. It is a monolithic design. As such, they don’t have extra costs associated in dealing with component manufacturers.

Their costs are largely controlled by the fact that they own their own process. None of the other system vendors do.

Literally, there is only one base cost for the PIC - no matter if 100GB or 2.4TB is provisioned on it. It has that much capacity.

So, when the customer turns on an additional 100GB - it is already there waiting to be turned on. There are no additional costs here. It is 100% profit.

Does that help?

Yes, that helps. It begs the question: why won’t gross margins exceed 50%, particularly if many customers will elect to add bandwidth later? Or is a 50% GM already baked into the model with the assumption that GM will be 50% if all 2.4TB are activated? Assuming overall company GMs can be higher than 50%, that would mean that operating margins could exceed the 15% goal/target that Fallon has set. Or will INFN keep spending 20% on R&D no matter how much revenue grows? Or will INFN keep issuing more and more stock-based compensation as the company exceeds expectations? As investors we can about EPS and EPS growth…market share growth and revenue growth are nice but not if these don’t translate into benefits for shareholders.

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Yes, that helps. It begs the question: why won’t gross margins exceed 50%, particularly if many customers will elect to add bandwidth later? Or is a 50% GM already baked into the model with the assumption that GM will be 50% if all 2.4TB are activated? Assuming overall company GMs can be higher than 50%, that would mean that operating margins could exceed the 15% goal/target that Fallon has set. Or will INFN keep spending 20% on R&D no matter how much revenue grows? Or will INFN keep issuing more and more stock-based compensation as the company exceeds expectations? As investors we can about EPS and EPS growth…market share growth and revenue growth are nice but not if these don’t translate into benefits for shareholders.

I cannot answer all of those questions directly. I do know that they are targeting 48.5% GM next quarter, pretty darn close to the 50% target already. They are also targeting 11% operating margin next quarter.

Transmode was a 60% GM company. As that business scales, I would suspect we actually should see margins north of 50%, especially if more and more customers turn on Instant Bandwidth.

I think more probing is required. What is the timeframe of those targets? Is it a 1 year target or longer term? Also, after following this company for such a long time frame they have a history of setting their guidance based on their own “conservative” estimates. Those “conservative” estimates always come as a surprise to analyst who had thought the guide would have been in a lower range. Then, when the next quarter comes they beat that guidance and proceed to guide even higher.

That’s what’s been going on for the past 7 of 8 quarters. So it naturally scratches my head when everyone seems to forget this after every quarter.

This is a great discussion. What other information can I offer or try to dig up with you?

Best,
–Kevin

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This is a great discussion. What other information can I offer or try to dig up with you?

Thanks Kevin. Not all of our questions can be answered definitively at this time. But as investors we care about how much we can make if we buy the stock. 48.5% GM is ok, 60% would be great. I currently have little visibility about how high GMs can get with this company. Fallon says they won’t cut prices to get business. I like that. But they have not offered anything more than saying that they will be a 50% GM company. This doesn’t tell me anything about what the potential is or is the potential only 50%??? There are 2 ways to increase GM: increase price or decrease COGS. The instant bandwidth is a way to lower cost per bandwidth; hopefully, this also allows INFN to charge more per bandwidth. Of course, the ability to raise prices can be influenced by what the competition is charging. It can also be influenced by what product features and specs the competition offers relative to INFN’s offering because a well differentiated product offering can maintain margin. From your postings and from what INFN management has been saying, the competition is falling more and more behind. If this continues then we should see some competitors starting to struggle in selling into some of INFN’s markets. Also, this would limit pressure on INFN to cut prices.

As a shareholder, I would really like to know how high GMs can get for INFN. I’m wondering what I’m missing as to why INFN can’t achieve higher than 50% GMs and why the company won’t say that they want to increase margins higher.

I also want to know why INFN isn’t setting its sights on achieving higher operating margins. A 15% target seems too low. Why can’t they reduce the percentage of sales/marketing, general/administrative, and R&D as revenues soar?

We have a lot of information about the overall market growth and potential and all of that looks good. It also appears that that INFN has the best mousetrap on the market. It also looks like they have a great plan on attacking the markets. I have a high level of confidence in these things. I have a lower confidence on how all of these great things translate into earnings and earnings growth. I’d like to see INFN build their business such that EPS soar along with revenue growth, marketshare growth, and world bandwidth growth.

Chris

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We have a lot of information about the overall market growth and potential and all of that looks good. It also appears that that INFN has the best mousetrap on the market. It also looks like they have a great plan on attacking the markets. I have a high level of confidence in these things. I have a lower confidence on how all of these great things translate into earnings and earnings growth. I’d like to see INFN build their business such that EPS soar along with revenue growth, marketshare growth, and world bandwidth growth.

What Monkey has been screaching on and on about. Thanks for the translation from animal to human, Chris.

Also: Skyworks has been drifting lower in the last few weeks. Sure, Apple said this quarter would be underwhelming, and Skyworks folks said it won’t be rocking nobody’s socks off, but the second half of the year will be better and better. So short sighted pre-earnings wariness? Or some larger industry “channel checks” or what-have-yous that don’t be looking so good? Either way, Monkey is staying the course in both SWKS and INFN because of their long term booty-kicking potential, so maybe this is all just (temporary) jungle noise by the birds.

Hmmm.

M
long SWKS & INFN

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I also want to know why INFN isn’t setting its sights on achieving higher operating margins. A 15% target seems too low.

I’m not Kevin, but I’ll take a stab at this one. Because they’d get laughed at.

It’s currently 6.7% as you said. You think they should be talking about going for 40%?!? I mean maybe eventually, but not in the near future.

Also, have you considered that if they do in fact more than double operating margin (6.7% to 15%), assuming it flows through to profit margin that will also double EPS. That’s a double! Before you even factor in revenue growth!!!

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It’s currently 6.7% as you said. You think they should be talking about going for 40%?!? I mean maybe eventually, but not in the near future.

Also, have you considered that if they do in fact more than double operating margin (6.7% to 15%), assuming it flows through to profit margin that will also double EPS. That’s a double! Before you even factor in revenue growth!!!

I was 13.1% in FY2015. The 6.7% number was GAAP which we’re not talking about. Going from 13.1% to a goal/target of 15% is not that impressive.

Also, I never said it should be 40%. 40% is where SWKS is approaching. My point is that SWKS has been growing revenue at a similar pace to INFN yet they have managed to leverage their opening costs. I would think that INFN could or should do better than 15%. The question remains why can’t they or why are they not trying to achieve better operating results. Is it because a) their business model doesn’t allow it, b) they can/will but management hasn’t spelled it out, or c) they could if they didn’t spend so much on R&D and stock-based compensation? Or is there some other reason.

Chris

I was 13.1% in FY2015. The 6.7% number was GAAP which we’re not talking about. Going from 13.1% to a goal/target of 15% is not that impressive.

Ok my bad. But that’s still good for a 15% bump to EPS if it carries through, again before factoring in revenue growth. Just sayin’.

The question remains why can’t they or why are they not trying to achieve better operating results. Is it because a) their business model doesn’t allow it, b) they can/will but management hasn’t spelled it out, or c) they could if they didn’t spend so much on R&D and stock-based compensation? Or is there some other reason.

Good question. My guess would be C. Sure they’re spending like a drunken sailor because they believe they’re in rapid growth mode (I agree). They’re still doing better than many tech companies (looking at you, Twitter) who sport operating margins in the NEGATIVE double digits. But I even believe in Twitter – there’s crazy revenue growth, and so you just have to decide if you believe it will ever get to the bottom line, like FB’s started doing a few years ago. I’m a believer.

INFN has said repeatedly that they intend to commit 20 percent to R & D, so with a 50 gross margin and an additional 20 gone to R & D you are left working, obviously, with 30 percent from which must come general selling and admin. etc. So to me 15 to 20 operating margin would be about all I would expect.
I know Yahoo is probably not the best place to look, but looking there anyway, SWKS spent around 8 percent on R & D. Their 8 percent is, of course, more money than INFN’s 20 percent, but if those numbers are correct that would explain 12 percent of the difference between the two operating margins.
General Selling and Admin, appears to be 20 percent for INFN, and again around 8 for SWKS, so there is another 12 percent.
I would think that this number would come down a lot as INFN grows.
Thoughts?
Mike

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I would think that this number would come down a lot as INFN grows.

I would think so too, and maybe they will tell us more Wednesday. I think seeing more flow to the bottom line would be nice. But I think even nicer (and potentially more jolting to the share price) would be for them to come out and say, “You know, we’re not actually going to keep growing revenue at this ~30% pace. We’re gonna grow it at 45% for a while.”

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