Wells Fargo on INFN

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Wells Fargo published its briefing notes on Infinera. While having a fresh perspective is certainly good, I think they are still coming up to speed on their understanding on how well Infinera is actually positioned. As a result, they are taking the conservative view and expect the stock to trade in range of 16-20 for the first half of 2016 and expect better things in the second half and into 2017.

The full briefing is copied below in italics. I’ve highlighted the parts that include the ‘safe words’ where they don’t exactly know where things will go, but leave the door open if their thinking serves them wrong. Very clever wording.

We are initiating coverage on shares of Infinera with a Market Perform rating and $16-$20 range, which applies a 17 times-21 times price/earnings multiple to our in-line with consensus calendar 2016 estimated earnings per share of 96 cents.

We are constructive regarding Infinera’s fundamental prospects and believe the company’s photonic integrated circuit (PIC) based products deliver best of breed performance that may continue to drive share in the 100G optical transport market. That said, with the long haul (LH) portion of this market (80% of sales) likely to slow in 2016, new data center interconnect (DCI) products just starting to ramp and Infinera early in the process of qualifying new metro offerings, we think the company may struggle to deliver the upside to consensus in 2016 we think is needed for the stock to work.

Photonic integrated circuits (PIC) share gains to continue, but may slow in 2016. We believe Infinera’s PIC-based products deliver superior capacity, spatial requirements, and power utilization versus competitive offerings, which has enabled the company to capture 608 basis points of LH share since the DTN-X launched during second-quarter 2012 and deliver 20%-plus growth each of the past three years (versus the market up high single digits). We think the industry-leading performance of Infinera’s products should enable the company to emerge as a long-term winner in the optical market. However, with much of the LH footprint decided and Infinera early in qualifying its metro products, we think share gains may slow in 2016 before potentially reaccelerating in 2017.

Metro and data center interconnect (DCI) products may take time to move the needle. With the LH transport market likely to see low- to mid-single-digit growth in 2016, we believe Infinera will need to capitalize on metro 100G upgrades and cloud interconnect opportunities to deliver the upside to consensus we think is needed for the stock to work. While we believe each of these markets is likely to see healthy growth in 2016, we believe Infinera will require time to qualify the recently acquired Transmode products with new customers and scale the DCI business to levels that move the needle, both of which may not occur until second-half 2016 or 2017.

Infinera’s PIC technology and decision to insource rather than outsource much of its manufacturing has enabled the company to deliver solid margin improvement as volumes have ramped over the last several years. While we think Infinera should be able to achieve its 50% gross and 15% operating margins over time (up from the 47.5% and 14.4% levels reported during the calendar third quarter), we believe the battle for metro 100G footprint and investments to accelerate share may temper the degree of leverage likely to be seen during 2016.

While we believe Infinera is a well-run company that appears well positioned to capitalize on carrier, cable operator, and web 2.0 100G optical investments, with the stock already trading at 17 times our inline-with consensus calendar 2016 EPS estimate of 96 cents, we think much of the good news is already reflected in valuation. To this point, we highlight that Infinera already trades at a healthy premium to the broader communications-equipment peer group at 15 times and key optical competitor Ciena at 10 times forward EPS, respectively.

Basically a non-committal view. Things could go swimmingly, or they could struggle a bit. Regarding margins, one thing I don’t think the analyst(s) at Wells Fargo had taken into account is when the LH market matures Infinera’s margins improve even better. That is why on the last conference call Tom said they have flexibility in their margin mix to be really aggressive in the new metro and DCI space while still protecting their current margin ratio. While the LH market is no longer in the aggressive build out as the past, Infinera came out the clear winner, and all of those customers will still need to turn to Infinera when it comes time to increase their speed through add on card purchases, this year and beyond. And those are the “razor blades” where all the juicy margins come from.

Infinera’s large install base in the LH market gives them a huge operational advantage in the fabrication process, plus “funding” flexibility to pursue aggressive pricing in the metro and DCI space IF and WHEN they need it. In this regard they are positioned very well. They have a lot of levers to pull. This will be an exciting year for Infinera.

Best,
–Kevin

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Some additional observations/comments on the WF model.

The model WF uses is based on the in-line view of 96 cents a share earnings for 2016 and assigns a 17 P/E for that view. While the 17 P/E may be viewed as extremely conservative, Infinera’s peers are currently priced at just 10-15 P/E to next year’s earnings. I will grant them this view, just for a moment, because a conservative viewpoint is a conservative viewpoint. However, there are two things to look for on the next earnings call that will change it.

First, we need to see if Ciena’s woes in achieving and predicting only single digit market share gains were due to Infinera’s increased gains from effectively beating them out. That will change minds on the 17 P/E granted from the WF analysts.

Second, we need to learn what the actual earnings delivered this quarter were and see what Tom & co say regarding guidance for the next quarter. That will change the prevailing .96 view and shoot the 2016 amount further north of a dollar. Remember, .96 is based on analyst expectations and Infinera has historically beaten these expectations.

If Infinera delivers another solid quarter - and all they need to do there is meet their own guidance - it will align with their market share targets, and it will tell us the reason for Ciena’s decline was due to competition with Infinera - rather than thinking the market opportunity size has suddenly shrunk. And it will force the models these analysts are using to be recalibrated.

When the size of the pie is the same and one company got a little less pie than expected, some company somewhere must have gotten a little more pie. There aren’t that many players in this space. Infinera has a solid brand and a strong reputation, and they can be competitive. That is a distinct advantage and will command more pie.

Just like every preceding quarter the team at Infinera had a doubting Thomas come out with a “prove me wrong” analyst viewpoint, and for the last two years of quarterly earnings they proved it every single time.

Best,
–Kevin

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While the 17 P/E may be viewed as extremely conservative, Infinera’s peers are currently priced at just 10-15 P/E to next year’s earnings.

Kevin, I’d be careful. While the market can certainly award a higher P/E, don’t assume it will.

I was laughing at S&P and making fun of them when they gave SWKS a 12-month target price of $65 at the end of 2014. And yet, despite wonderful growth, excellent execution, and not a single hiccup from the business, here we are at $65.17 as I write this. All I can do is shake my head at the craziness of it, but that doesn’t change reality.

We look at businesses differently than the broader market does (obviously, or there’d never be any opportunity for us). A stock price is a combination of both a businesses’ earnings and how much the market is willing to pay for those earnings. We can get to know a business well and make some intelligent guesses about where their earnings may head over the coming years, but trying to guess what the market will think is a fool’s errand.

I mentioned before that my huge mistake in 2015 was assuming that the market would be willing to pay up for excellent earnings growth and execution, and as a result I was willing to accept higher P/E’s for solid, proven companies with very low 1YPEGs. But the market is very fickle and skittish, and would much rather shoot first and ask questions later, and the result can be hard on a portfolio left exposed to the market’s whims.

The other lesson from 2015 is that even the best of companies will go on deep discount from time to time, from a value perspective. That’s the time to load up on them, IMHO, not on a little 10% or 20% dip that still leaves them trading at above-average historical P/E’s. Aggressively adding on those dips – which later made it hard for me to take full advantage when the stock went on a deep discount – was another mistake I made.

Moving forward, I’ll be paying a lot more attention to accuracy. To be clear, I’m not advocating for price anchoring (that is a terrible trait in an investor), but rather a more informed approach to portfolio allocation in terms of historical valuation ranges so that (1) I’m not leaving myself unnecessarily exposed to the whim of the market, and (2) I have the ability to take full advantage when the market does put a great company on deep discount. There’s nothing wrong with a small allocation to a high-flying great company with a bright future, but I want my portfolio weighted towards great companies with bright futures that are also historically cheap.

Just a few thoughts. I don’t think there’s really anything new in them, but I do have a new appreciation of them now :wink:

Neil
Long INFN, SWKS

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The other lesson from 2015 is that even the best of companies will go on deep discount from time to time, from a value perspective. That’s the time to load up on them, IMHO, not on a little 10% or 20% dip that still leaves them trading at above-average historical P/E’s. Aggressively adding on those dips – which later made it hard for me to take full advantage when the stock went on a deep discount – was another mistake I made.

Ditto all of that, but easier said than done.

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