This post excerpt below is roughly nine months old. I’ll take some credit for analysis, but there are other important reasons why months-old information is still relevant. The management team at Infinera has a great understanding of future directions for the markets they’re selling into and they are quite transparent in their disclosures during earnings conference calls. Thus, investors gain great insight into where the company is headed.
Infinera beat revenue and earnings expectations and offered guidance for 3Q15 that was well above Wall Street’s expectations. All of this occurred despite a slower-than-expected ramp-up of Cloud Xpress. What I see as even more exciting, though, is the long-term opportunity that faces Infinera – one that Chief Executive Officer (CEO) Tom Fallon animatedly described as “shocking!” I’ll share with you what he sees, and you can decide whether you agree with his assessment. [Did you notice that little attempt at optical-electrical-optical conversion in those last couple of sentences? I couldn’t resist.]
Seeking Alpha’s transcript of the conference call can be found here: http://seekingalpha.com/article/3361695-infineras-infn-ceo-t… (Thanks for making the transcript freely available, Seeking Alpha.) Unless stated otherwise, all italicized quotations are from the Seeking Alpha transcript.
Although Infinera indicated that the ramp-up of Cloud Xpress sales is progressing more slowly than expected – CEO Fallon used the word “surprised” repeatedly – the commentary around this was far from negative (although the Wall Street analysts seemed to adopt a more dour view). There are several reasons for the slower ramp-up, as well as for continued optimism. I think it’s worthwhile to explain them. If we understand management’s explanations, we can better understand future quarters’ results.
Longer Evaluation Cycle
I trust this management team, so I’m inclined not to write this explanation off as “spin”, although it could certainly be viewed as such. It seemed that management expected a less rigorous review process for this product (or at least less rigor from the market participants that it primarily targets). CEO Fallon said, “I assumed people would buy it somewhat like an appliance …” By this, I assume he meant that that one does a bit of up-front research, comparing various models sizes and features against one’s particular needs. Then one makes a purchase and moves on with life. Instead, he finds that these purchases are being “certified much more classically”. While this adoption pattern takes longer to ramp up, CEO Fallon views it as a long-term positive. He reasons that companies wouldn’t invest so much energy into the certification process if they didn’t anticipate this piece of hardware being “an architectural piece”, meaning that they view it potentially as a significant part of the network architecture, and the initial purchase could be the proverbial tip of the iceberg. So management took pains to guide analysts away from the higher end of their unit sales predictions for 2015, and this may have been a factor limiting INFN price gains after the earnings conference call. But it sounds good from a longer-term perspective.
“No Thanks. We’ll Wait for 100G.”
As you may recall, Cloud Xpress comes in 10G, 40G, and 100G versions. At this point in time, 10G-compatible hardware is prevalent in most data centers and 40G and 100G have much smaller market shares. So it is understandable that Infinera rolled out the 10G early – it was probably expected to be the mainstay of the market, reflecting what’s currently in data centers. Certain customers pleaded for acceleration of 40G development, apparently, so that was delivered early, too. Where management may have misread the market was in failing to recognize that 100G is where dollars are waiting to be spent currently. They announced the availability of the 100G version in June, and expect shipments to start in Q3. Management has apparently already gotten feedback from customers indicating, “I’m just not going to deploy this now when I can get 100 gig in Q3”. I think this misreading of the market hurt current sales, but bodes well for upcoming quarters. Regarding the introduction of the 100G version, CEO Fallon anticipates a “positive inflection point”.
“We’ve Been Shipping”
An analyst asked about recent announcements of products competitive to Cloud Xpress. CEO Fallon noted, “We view these announcements as validation for the magnitude of the overall metro cloud opportunity. In this market, Infinera has a significant technology and first mover advantage. Our product is in the market today with a [PIC-based] approach that offers tremendous capacity, carrier-class reliability, appliance-like ease of use and minimal power and space requirements.” He further pointed out, “The biggest skew right now that causes the customer to buy from us versus the competition is that ours is the only product shipping and there is a ton of great slideware out there that talks about all kinds of features and I look forward to our competition starting to ship something and we’ll go and do the analytics. We have a very good feeling about where we stack up, but I think that the biggest differentiator today, we’ve been shipping, we’ve been shipping for three quarters and nobody else is shipping.”
One final encouraging note regarding Cloud Xpress is that four Cloud Xpress customers have come back and purchased even more units. This seems to further support the notion that Cloud Xpress will become an important part of certain customers’ network architectures.
“Shocking” Market Opportunity
The long haul and metro aggregation markets are each growing at around 8-10% per year, yet CEO Fallon talks about a “shocking” market opportunity. What does he see that gets him so animated?
Asked whether Infinera could exceed 10% growth long term in the long haul market, CEO Fallon answered, “I don’t think we could” (warning: the Seeking Alpha transcription completely reversed what he said in this specific answer). To grow faster than the market, you need to take market share away from your competitors. Infinera has been pretty good at that to date, but that is very difficult to continue to achieve in the long term. Long haul, though, is not where Infinera expects to see its strongest growth.
Infinera recognizes that its core technology – the Photonic Integrated Chip (PIC) – is also relevant in markets adjacent to long haul, and this year and next year mark the beginnings of Infinera’s major moves to address two of those adjacent markets.
The first adjacent market seems to go by several names. It is a relatively new market, so I guess that happens. If I’m not mistaken, “data center interconnect” (DCI), “cloud-to-cloud”, and “metro cloud” seem to all refer to the nascent market that Cloud Xpress is designed to address. The market opportunity is currently measured in the hundreds of millions of dollars, but it should be in the billions within a few years. Last year, one respected industry analyst predicted a 78% compounded annual growth rate (CAGR) for this market over the following five years. That’s pretty amazing, and Infinera has “first-mover advantage” in this market, and hopes to be able to maintain “best-in-class” status as well. Given its lead in PIC technology, this may not be unreasonable. Within a few years, this market is expected to grow to a size similar to long haul today. This expected market growth pattern, and size as well, is what makes the Cloud Xpress opportunity so exciting.
The second adjacent market is metro aggregation. This is an established market and one that is growing at a pace much more akin to long haul. Infinera’s opportunity is different here, and it has a two-pronged approach. Infinera currently has a low single-digit market share in this market, despite their current product not being optimized for this market. Later this year, at least one of two things will happen. Hopefully the first thing that will happen is that Infinera’s acquisition of Transmode will succeed. Should that occur, Infinera will immediately gain a suite of products that broadly addresses this market. Transmode is relatively small, and their presence is mostly felt in Europe, so Infinera’s market share would still be relatively small. But Infinera sees two opportunities here. First, it can leverage its larger and more geographically-diversified sales force to introduce Transmode’s products to a larger potential customer base. Second, where appropriate, Infinera can improve Transmode products by incorporating PIC technology. These two factors should help Infinera grow their metro aggregation market share out of the low single digits. The second event (prong, if you will) will be Infinera’s unveiling of its PIC-based product for the metro aggregation market. Annually, in the fall, Infinera holds an event called “Insight Infinera” to showcase its products. You can bet that Infinera’s metro aggregation offering will be the highlight of this event (the spotlight might potentially be shared with Transmode products). This new product is the other method that Infinera hopes to employ to gain significant share in the metro aggregation market.
I think the following quote from CEO Fallon is quite telling regarding how Infinera views its future in its core market and the adjacent ones it seeks to capture. “If you look at our market share in long haul, I can tell you I’m not going to over a period of time accept anything less than that kind of market share in the larger market that we are going to go pursue. That’s going to take some time and some work. And I don’t want everybody to believe that this is going to be a linear up [and to] the right kind of progression. But our strategy over the next several years is to recreate our success in the long haul by leveraging our core technologies and optimizing them and going into adjacent spaces that will allow us to fundamentally triple the market we’re serving. [You psyched me up!]” Later in the conference call, founder and President Dave Welch estimated that Infinera’s market share in long haul is approximately 40%.
If Infinera really can execute on the roadmap it has planned, it is indeed on the cusp of a shocking opportunity. It seems well-positioned in the small but fast-growing metro cloud market. In metro aggregation, its two-pronged approach certainly has potential to lead to market share gains, even if not quite as grandiose as what CEO Fallon envisions. Skepticism is always appropriate, but one must consider that Infinera has already proven that it can achieve a goal like this. The long haul market was well established before Infinera was founded. Other companies had strong positions in the 10G market before the DTN was announced. With DTN, and later DTN-X, Infinera has grown to be a dominant force in the long haul market. Why should we assume that successful expansion into adjacent markets is implausible? This expansion seems to be a natural progression, since it doesn’t require a brand new technology, and there is a fair amount of overlap with Infinera’s existing customer base. The opportunity is large, yet the path Infinera must tread will likely be less arduous than that faced by most companies aiming for similar-sized opportunities.
Thanks and best wishes,
TMFDatabaseBob (long: INFN)
Peace on Earth