Fiber optic systems provider Infinera (NASDAQ:INFN) recently announced that it will buy industry peer Coriant for $430 million ($230 million in cash and $200 million in stock). Infinera expects the deal to close during the third quarter of 2018 if it clears regulatory requirements in the US, Germany, and Russia.

Infinera has over 600 customers worldwide, while Coriant has over 500 customers. Both companies have about 2,100 employees. Infinera expects the acquisition to roughly double its annual revenues to over $1.6 billion, nearly quadruple its number of patents, and become earnings accretive in fiscal 2019. Let's dig deeper into the four key reasons Infinera bought Coriant.

A closeup view of a fiber optic cable.

Image source: Getty Images.

1. Coriant's Metro and DCI businesses

Infinera generates over half its revenue from Long Haul WDM (Wave Division Multiplexing) optical transmission systems, which allow carriers to increase the capacity of long-distance networks without laying down additional fiber.

Infinera generates less revenue from its Metro and DCI (data center interconnect) solutions, which boost the capacity of urban and data center networks, respectively. Demand for Long Haul WDM solutions tapered off in the second half of 2016 and the first half of 2017 as carriers focused more on Metro and DCI solutions, and a slowdown in China's telco spending exacerbated that pain.

Those headwinds have been fading in recent quarters, but Infinera likely realized that it needed to beef up its Metro and DCI businesses to protect itself from cyclical downturns. Buying Coriant -- which generates over half of its revenue from Metro, Mobile 5G, IP Edge, and DCI solutions -- would increase Infinera's presence in higher-growth markets and reduce its dependence on Long Haul WDM solutions.

2. Challenging the market leaders

On its own, Infinera struggled to compete against bigger optical vendors like Huawei, Nokia (NYSE:NOK), and Ciena (NYSE:CIEN). But after buying Coriant, Infinera will become the largest player in the disaggregated transponder market (which breaks up monolithic systems to prevent vendor lock-in) and the second largest provider of 100G+ (100G, 200G, and 400G) ports after Huawei.

The combined company will serve nine of the world's ten largest carriers, and all six of the largest web-scale ICPs (internet content providers). Infinera says that it has minimal customer overlap with Coriant, with nine out of both companies' top ten customers being unique. The combination will also reduce Infinera's customer concentration as revenue from its top ten customers drops from 65% to 45%.

Network connections sprawling across a city.

Image source: Getty Images.

Scaling up before carriers aggressively ramp up their mobile and 5G upgrades is a smart move, since it will give Infinera more bundling firepower against its competitors.

3. Savings and economies of scale

Infinera's improved scale should help it generate $100 million in savings in 2019, driven by operational integrations. It expects to save another $150 million throughout 2020 and 2021 thanks to additional operational and vertical integration benefits. Infinera's purchasing power would also improve.

Moreover, it expects the acquisition of Coriant to help it skip the "multi-year process" required to win over certain Tier-1 customers. That would help it avoid paying acquisition break-in costs between $10 million and $20 million per customer.

Infinera expects those improvements to eventually boost its non-GAAP operating margin to 15%, which would be a remarkable improvement from its non-GAAP operating margin of negative 10.1% in fiscal 2017. Ciena and Nokia reported non-GAAP operating margins of 11.9% and 11.1%, respectively, in their latest fiscal years.

Infinera also expects its non-GAAP gross margin -- which came in at 32.9% last year -- to rise to 36%-38% after the acquisition and exceed 50% after 2021. That would also beat Ciena's non-GAAP gross margin of 45.1% and Nokia's non-GAAP gross margin of 41.7% last year.

4. A compelling valuation and a clean balance sheet

$430 million is a massive purchase for a company expected to generate just $836 million in revenues this year. Infinera will also need to take on more debt to finance the deal, since it finished the first quarter with just $151 million in cash and $113 million in short term investments.

However, Infinera notes that Coriant has no debt, and that the $430 million price tag values the company at just 0.5 times its annual revenue. Infinera also expects the deal to pay for itself within three years.

The key takeaways

Infinera's stock already rallied about 40% this year as the company's sales growth accelerated on brightening prospects for the Long Haul WDM market. Buying Coriant to diversify its business and scale up its bundling capabilities is the right move at the right time, since market demand should heat up quickly as carriers ramp up their 5G upgrades.

 

Leo Sun has no position in any of the stocks mentioned. The Motley Fool recommends Infinera. The Motley Fool has a disclosure policy.