Monday, September 27, 2010

Infinera (NASDAQ:INFN): Downgrade to Sell, expect a miss n-t - Goldman Sachs

Goldman Sachs is making a significant negative call on Infinera (NASDAQ:INFN) downgrading the name to Sell from Neutral with a $8.50 price target (prev. $7.50).

Firm notes they downgrade INFN to Sell from Neutral following the stock’s 100% rally over the last three months on a combination of risk to estimates and full valuation. While the market appears to be pricing in robust growth going forward, they see Infinera’s opportunity as more limited over the next 12-18 months as a result of: 1) the market’s transition from 10G to 40G, where Infinera doesn’t have a native solution; 2) intensifying pricing pressure in 10G; 3) peak gross margins in 3Q2010; and 4) a possible inventory correction at customers. They also view valuation as full at a CY2011 EV/S of 2.1X, vs the CIEN/TLAB/JDSU average of 1.1X. Goldman's $8.50 price target implies 34% downside potential.

Goldman expects Infinera’s results to disappoint over the next few quarters, with their CY2011 sales/EPS estimates 13%/66% below consensus due to the significant operating leverage in the model. While they believe the market extrapolated the recent quarter’s strength to next year’s estimates, the firm expects sales to moderate or even decline over the near term, as supply chain shortages get alleviated and as Infinera will likely lose share in the 40G transition. Longer-term, that strength appears unsustainable, as Infinera’s pace of new customer additions has declined to three per quarter in 2010 from five per quarter in 2007, and its peak margins suggest that its mix of business is heavily skewed to line cards (i.e., shipments to existing customers) rather than the more forward-looking common equipment (i.e., new footprint buildouts).

Goldman sees meaningful risk to Street estimates with their CY2011 sales estimate of $477 mn – 13% below the Street at $545 mn – due to several factors described in more detail in the note, and EPS is 66% below consensus due to Infinera’s significant operating leverage given its vertically integrated business model. THey believe the Street erroneously extrapolated Infinera’s recent strength – with 2Q sales up 16% qoq – into the future, interpreting it as a reflection of strong secular growth opportunities. In contrast, the firm believes the optical networking market remains challenging, with enormous pricing pressure offsetting strong volume shipments to drive only single-digit revenue growth. They believe the recent strength in Infinera’s business may have been due to its customers’ attempts to alleviate supply constraints, as its new customer additions decreased to an all-time low. This could set Infinera up for a pullback, similar to that recently experienced by component vendors PMC-Sierra and Exar, when its customers’ inventories catch up with demand. In addition, we view the transition from 10G to 40G currently underway as a negative for Infinera, given its recent decision to skip from 10G to 100G in its proprietary product roadmap, and to address the 40G node with a merchant solution. Lastly, they expect Infinera’s gross margins to reach their historical peak levels this quarter, which could limit operating leverage going forward, signifying a mix of business that is more driven by line cards (i.e., harvesting prior design wins) than chassis (i.e., building new footprint).

Lastly in terms of set-up, Goldman notes the significant decrease in short interest over the last few months following Infinera’s strong 2Q results. Given the stock’s 100% move over the last three months and significant short covering, they don’t believe their below- Consensus estimates are reflected in the current stock price.

Notablecalls: The call reads badly. Goldman sees multiple headwinds ahead while the stock is sporting a fairly high valuation. The high valuation is due to current tech environment where every small player with a technological edge seems to be in play.

But hey, didn't Goldman just say INFN doesn't have much of a tech edge? Infinera’s 100G solution is late to market, behind CSCO, ALU, Huawei etc.

Goldman is also calling for a miss over the next few quarters, which is usually bad news for a co that trades 30x EPS.

Anyway, I think INFN will trade down today. Not going to get crushed, though.

Trades towards $12 or possibly below (in case the general tape exhibits some weakness).

PS: (update 8:49AM ET) Pacific Crest is raising their tgt on INFN to 20 frm 12. So careful shorting this one.

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