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3 Big Risks Infinera Investors Need to Watch

A man pulls a piece from a Jenga tower

Investors in Infinera (NASDAQ: INFN) are likely at a crossroads. On the one hand, the opportunity in optical networking is huge. People want faster internet, and they want it soon! Infinera's products meet the need for exploding bandwidth. Yet the stock is down more than 25% over the past year.

Infinera's opportunity is big. The company explains that its wavelength division multiplexer technology (WDM) lets telecommunications companies boost capacity without installing more fiber. According to Wintergreen Research , the market for dense wavelength division multiplexer technology (DWDM) equipment will reach $9 billion by 2018, up from $4.3 billion in 2011. And the Dell'Oro Group forecasts that the overall market for WDM (including both DWDM and CWDM, coarse wavelength division multiplexer, which Infinera also produces) will reach $15 billion by 2021, with 80% demand growth for wavelength speeds greater than 100 Gbps. .

Still, Infinera's stock fell over 50% in 2016 on declining revenues, margins, and earnings. And while the company has strongly rallied since its most recent earnings report(, which was less bad than expected, questions still remain. This is because revenues were 30% below the previous year's Q4 , margins compressed, and earnings turned negative.

Going forward, investors may wish to focus on three particular risks. Each of the three are part of Michael Porter's "five forces" of industry competition, not to be confused with Fox Force Five , the fictional TV show Uma Thurman's character starred in in the movie Pulp Fiction .

Five forces every investor should know

Porter's five forces are rivalry (intensity of competition), supplier power (how much bargaining power do suppliers have), buyer power (how much bargaining power do customers have), threat of substitutes (as in cars displacing the buggy whip industry), and the threat of new entrants.

The main risks I see in Infinera reside in rivalry, buyer power, and the threat of new entrants. Let's dig further into each one.

A man pulls a piece from a Jenga tower

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Infinera is certainly a leader in the WDM market, but there is competition. According to its 2015 annual report, it competes mainly with five other leading-edge companies in the long-haul market, most notably Ciena (NYSE: CIEN) , along with four other market rivals in the metro market, including tech behemoth Cisco (NASDAQ: CSCO) .

Competition was fierce last year as end customers paused their expenditures in optical networks. Infinera management said that according to the Dell'Oro group, the standard 100 Gbps circuit that Infinera sells experienced price deflation of 29% in 2016 .

But competitor Ciena announced that it had managed to slightly increase its revenue in that difficult year and said it had a record backlog. Moreover, its fourth-quarter gross margin expanded to 44.5% from 43.8% in the prior year , which is a stark contrast to Infinera's fourth-quarter gross margin of 41.8%, a decrease from 48.3% in the previous year's quarter.

As prices dropped so heavily, it is clear there is cutthroat competition between the players, and that Infinera lacks a technological differentiation -- at least at this point -- to maintain its prices. The company is hoping its Infinite Capacity Engine product, which can transport data at 2.4 terabytes/second and is slated to launch later this year, will change that.

Buyer power

Another potential red flag for Infinera is the concept of buyer power. This comes into play when a company can only sell to a limited number of buyers, so these buyers are able to call the shots in negotiations. After all, if you can only sell to one or two companies, what leverage do you have?

Infinera sells to a range of Tier 1, 2, and 3 carriers, content providers, cloud operators, wholesale and enterprise carriers, and others. Still, it may indeed suffer from too much customer concentration. In last year's annual report, the company said that two of its customers accounted for 17% and 13% of its sales, respectively. That's not too dire, but still a higher concentration than one would like. In the most recent conference call, the company also stated that two customers once again made up 10% or more of its sales ( ).

If that weren't enough, two of its big customers -- CenturyLink (NYSE: CTL) and Level 3 Communications (NYSE: LVLT) -- are slated to merge later this year, and a larger customer could exert more pricing pressure on Infinera. .

Threat of new entrants... (namely from China)

Finally, this is technology investing. As with any technology, a company can face low-cost competitors from tech-savvy countries with lower labor costs. In particular, in 2015, China announced a plan to spend $1 trillion over 10 years to develop its own homegrown chip companies (. Assuming a young upstart develops its own WDM technologies with similar capabilities to Infinera, and at a lower price point, Infinera may find itself in a position so many companies, from steel to shoes, have experienced in other sectors over the years -- facing low-priced competitors from China. While this is no doubt a speculation, and potentially far off -- China may also focus on other chips besides WDM technologies -- any potential start-up that wishes to get into this growing market could put serious pressure on Infinera.

To be sure, Infinera may come out the other end of this trough much stronger than before, and at these price levels, you are still getting the company for more than 50% off its all-time highs. Nevertheless, Infinera should keep an eye out for further pressures of rivalry, buyer power, and new entrants going forward. Investors looking only at the growth potential in bandwidth capacity are missing part of the picture and should also focus on these risks with eyes wide open.

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Billy Duberstein owns shares of Level 3 Communications. The Motley Fool owns shares of and recommends Infinera. The Motley Fool recommends Cisco Systems. The Motley Fool has a disclosure policy .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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