2023-12-15 08:46:49 ET
Summary
- Infinera's financial metrics have been improving, but the company still needs to prove its profitability before it's a good investment.
- The company specializes in optical networking solutions and has products that are cost-effective and efficient.
- Infinera has a significant amount of debt and its ability to manage it is a concern, making it vulnerable to economic downturns.
Investment Thesis
Infinera ( INFN ) has been trending down for the last year and is currently down around 30%, so I wanted to have a look at the company´s financials because it was suggested to me by a friend of mine. Unfortunately, the company is at a stage that I do not particularly like to bet on because of the uncertainty of profitability going forward. The metrics have been improving considerably, however, the company still has a lot to prove to me before I commit any capital, as talk is just talk. Therefore, I give it a hold rating for now.
Briefly on the Company
INFN is a global supplier of optical networking solutions and specializes in high-performance hardware and software to make the transmission of data much more efficient and reliable.
The company´s products include photonic integrated circuits which are these small components that combine electronic and optical functions It uses tiny light-based circuits to process information. The advantage of this product is that it is much faster and cooler, which allows for more processing power without overheating, unlike regular chips.
The company also provides coherent optical engines that increase data capacity and transmission distance.
The advantage of INFN´s products is that they are built to be cost-effective with an increased capacity, like the company´s 800G product, which significantly boosts data transmission speeds and can handle a lot more volumes of data.
Their modular setup allows for an easy upgrade to the systems without the need to replace the whole system and that is much more cost-effective.
Financials
As of Q2´23 (the latest quarter is unavailable because the company couldn't prepare them on time), INFN had around $165m in cash and equivalents, against $676m in long-term debt. That´s quite a lot of debt for a company that barely has a billion-dollar market cap. Usually, I don't mind when companies employ debt to fund their operations and further the growth of their company, however, only if the company manages the leverage smartly. I look at a few solvency ratios to decide whether the company can manage the debt. Spoiler alert, it is not looking good for INFN. The debt-assets ratio is decent and is within an acceptable number, which is below 0.6. As of Q2, it's at around 0.43, so still all good there. The debt-to-equity ratio is where the company begins to look worse. FY19 numbers were still decent, however, after acquiring more debt and incurring further losses, this lowered the total shareholder equity considerably, and it's been eroding ever since. D/E deteriorated to 3.74. I consider a D/E ratio up to 1.5 to be acceptable, so this is well beyond that. Lastly, I like to look at the company´s ability to pay its annual interest expense on debt. Over the last while this number has gotten better, however, it is still in the negative territory, which means that the company is not able to cover its debt obligations with operating income as that has been negative throughout the years. Many analysts consider an interest coverage ratio of at least 2x to be healthy, I would consider 5x to be much more sufficient to account for the downturns in the economy when the company´s operations may perform badly.
The company heavily depends on financing its operations through debt, which makes it a lot more vulnerable to economic downturns and rising interest rates. The latter may not be the worst now since it looks like the Fed is taking more of a dovish stance, however, we may not be out of the woods yet in terms of economic downturns. The good thing is that the company´s operating income is improving steadily, and it looks like INFN will be GAAP-positive in the next year or so if everything goes well. The big worry for me is that if the operations do not improve the company will have to take on more debt or issue more shares to keep surviving, and that is not ideal. I am going to assign a much larger margin of safety due to these risks.
The company´s current ratio has been consistently above 1 in the last 5 years, which is very good. In the most recent quarter, it sits at around 1.7, which is right in the middle of what I consider to be efficient. This tells me that the company can cover its short-term obligation with ease, while also having enough left over for any further growth of the company. So, at least right now, it looks like the company has no liquidity issues.
The next metrics I consider very important if I were to invest any capital into the company. The company´s ROA and ROE have not been good at all. I am looking for at least 5% on ROA and 10% on ROE, however, these are negative right now. On a positive note, we do see some improvement over the years, but it is not sufficient enough. The company needs to grow at a much faster pace than the costs if it wants to be profitable and create value for its shareholders. The management has not been using the company´s assets and shareholder capital very efficiently over the years, but it does look like these metrics are improving.
The same can be said about the company´s ROIC. This metric is the most important I look at and that has the most weight on what kind of margin of safety I will be setting in the end. I look for at least 10%, which tells me the management is allocating capital efficiently and is creating value. So far, that has not been the case, so for me to take on the risks of a company that looks like has no competitive advantage or a strong moat, I would have to assign quite a large margin of safety.
It looks like the company is trending in the right direction; however, we don't know if this is going to continue going forward and if the company will soon be in positive territory. For this reason, I would be assigning a higher margin of safety if I were to own a company like that.
The company´s margins have been experiencing the same improvements, however, as you can see, GAAP margins are quite awful still. The management is having a tough time controlling expenses. Stock-based compensation is a big drain on the company, which accounted for around $33m in Q2.
Overall, there is very little to like here, except for that improvement in all of the metrics. They are still very much in the negatives, and I don’t like to bet on the company´s turnaround because I like to invest in companies that already have proven themselves to be efficient and profitable for a while now, and if those companies trade at a discount, then that is the perfect company to invest in. So far, I don’t feel that INFN is the right company for that long-term investment as its future is still not very certain.
The company has been growing at around 13% CAGR over the last decade, which is decent enough, however, that seems to slow down to around 1% for FY23 according to analysts , and only a slight bounce the year after. I don´t look at numbers that are still over 12 months away because it is impossible to predict what kind of environment we are going to experience, however, the best we can do is to take an educated guess and go from there. It seems that analysts are not very positive about the company´s outlook.
Comments on the Outlook
This may not be a serious thing but also it may be. The company received a non-compliance notice from Nasdaq due to failure to file its most recent 10-Q. It has been given until January 9 th to rectify this issue. This could bring about a lot of volatility in the company´s share price and may keep the share price down for a bit.
The company may also suffer reputational damage and risk of delisting if it doesn't submit the report by the deadline, however, an extension can be granted once again.
The management mentioned a couple of times that the company will deliver $1 of EPS in ´25, and ´26, which if it´s true, is quite a lift from what the company has been doing historically. I´m also sure the management means $1 of adjusted EPS and not GAAP. That is a hefty goal, and their reason is that the company has made many investments in different sectors like the subsystems business. The company has invested heavily in vertical integration in the metro platforms, and the payback begins next year, which should be around $0.30 EPS extra. That may well be true but with such goals, I´d like to see the result already coming in over the next couple of quarters before betting my house on the company´s profitability just on their word. I know that they are not going to be lying about it, but I just like to be more cautious with such words. INFN´s 400G ZR/ZR+ pluggables are now commercially available, which should play a large role in the company´s further margin of expansion. This should be achieved sometime in the second half of ´24.
INFN´s 800G is on track to be delivered, which will be its highest-performing and lowest power consumption product. So, what I´m hearing is that it is still a ways away for the company to achieve much better results, and what´s interesting is that the share price doesn't seem to reflect this optimism at all. $1 of EPS would make the company trade at a 4x PE ratio, and yes that is very cheap, but somehow the company´s share price has been trending down over the last year and has a massive 20% short interest.
The company previously was looking to be sold . The company was worth $1.5B at the time. I don't know if that is still on the table but that could be one way of either boosting its share price in a short time or bringing it further down.
Overall, as I said earlier, I will be conservative with my estimates for the company for that extra margin of safety. The company is going in the right direction but I need to see an acceleration in improvements before diving in and believing that the company will trade at a PE ratio of 4.
Valuation
I usually like to approach my valuation estimates with a good margin of safety, so I tend to lowball estimates slightly to achieve that. I decided to grow revenues at a lower than the company´s average because, in the last 3 years, the growth was not particularly strong. FY20, FY21, and FY22 saw 4%, 5%, and 10%, respectively. I went with around 7% CAGR for the next decade for the base case. To cover my basis, I also included a conservative and an optimistic case. Below are those assumptions and their respective CAGRs.
For margins and EPS, I decided to use the company´s non-GAAP margins because the other ones are quite horrendous and I´m not sure if the company will be GAAP positive any time soon, however, if we look at non-GAAP numbers, the valuation has a chance of being somewhat reasonable. Below are those assumptions.
For the DCF calculations, I used a 10% discount to get that extra margin of safety, as the company´s WACC of around 6% seemed to be too low for me. I also went with a 2.5% terminal growth rate. On top of these assumptions, I also decided to add another 30% margin of safety because of how uncertain everything I´ve mentioned previously is. With that said, INFN´s intrinsic value (loose) is around $3.34 a share, implying that even with non-GAAP metrics, the company is well over its “fair value”.
Closing Comments
The company doesn't fit my investment style at all, so for that reason, it is not a good time to start a position as it would be too much of a gamble on my part. There is only one thing that makes me interested a little bit is the potential for a turnaround, however, even then, I cannot be certain it´ll manage to do that soon. I would say INFN would be a contender a couple of years from now if all goes well but right now, I don’t think I would be eager to start a position even if the company does retreat to that PT above.
Thanks to the person who suggested I look into the company but I´m sure this is not the answer they wanted to hear, as I believe they already invested some money into it.
For further details see:
Infinera: I'd Like To See Company Become GAAP Profitable Before Jumping In