Did Investors Overreact to Infinera’s $200 Million Debt Offering?

Infinera's (INFN -0.20%) stock recently plunged after the optical solutions provider announced a new offering of $200 million in 2.5% convertible senior notes due in 2027. When the notes mature, every $1,000 in principal can be converted to cash, 130.5995 shares of Infinera's common stock (which translates to $7.66 per share), or a combination of both.

Infinera can also redeem the shares for cash on or after March 5, 2024, but only if its stock price rises to at least 130% of the conversion price for more than 20 trading days during a 30-day trading period. If that happens, the notes will be redeemed at 100% the principal amount plus accrued and unpaid interest. Infinera also granted its initial buyer a 13-day option to purchase an additional $30 million in notes.

Image source: Getty Images.

Investors clearly weren't pleased with the abrupt announcement, since Infinera didn't hint at a new debt offering during its recent fourth-quarter report. Instead, CFO Nancy Erba told investors to expect a "meaningful improvement" in its operating cash flow in 2020 during the conference call.

But the offering also wasn't surprising, since Infinera has been aggressively investing in new projects -- including XR optics with Lumentum (LITE -0.12%) and new 800G products -- over the past year. Infinera plans to use the proceeds for "general corporate purposes, including working capital to fund growth and potential strategic projects." Let's dig deeper into Infinera's finances to see if investors overreacted to the news.

Rising debt levels over the past three years

Infinera didn't have any long-term debt in 2017. However, its long-term debt surged to $266.9 million in 2018, and climbed another 21% to $323.7 million in 2019. It also ended 2019 with $31.7 million in short-term debt, compared to zero short-term debt in 2018 and $144.9 million in 2017.

Image source: Getty Images.

As a result, Infinera's debt-to-equity ratio rose from 0.5 in 2017 to 0.7 in 2018 and rose again to 1.9 in 2019. The newest $200 million offering could boost that ratio to between 2.0 to 3.0 in 2020 -- which means that it will owe $2 to $3 in debt for every dollar of equity.

Infinera's debt surged over the past three years for three main reasons. First, its cash flow dried up as demand for its long-haul optical solutions, which generated most of its revenue, dried up in 2018. That slowdown occurred because service providers prioritized shorter-range upgrades for metro and data center networks.

Second, that slowdown prompted Infinera to acquire its rival Coriant, which boosted its exposure to those shorter-range markets, for $230 million in cash and $200 million in stock in late 2018. Lastly, Infinera ramped up its production of next-gen 800G products in preparation for network upgrades in the second half of 2020.

Why are investors so worried about the latest offering?

Infinera's decision to take on more debt make sense, but investors seem concerned about its ongoing losses and its cash burn rate over the past year.

Millions USD. Source: Infinera quarterly reports.

Infinera expects its revenue and gross margin to decline sequentially in the first quarter, due to seasonal headwinds and the novel coronavirus outbreak, so investors shouldn't expect the company to generate positive operating cash flow anytime soon. Interest payments on its new notes should exacerbate that pain.

Investors are also likely worried about stock dilution. If all the issued notes are converted to stock, Infinera's number of outstanding shares would rise by about 14% from current levels. However, Infinera would still trade at less than one times its annual revenue in that worst-case scenario -- so dilution shouldn't be a major issue.

Did investors overreact?

As an Infinera investor, I don't think its debt offering was a red flag. It's merely planting the seeds for future growth -- specifically in the XR and 800G markets -- and it needs to shoulder more debt to accomplish that goal. The stock is still cheap, and its long-term prospects still look bright as service providers upgrade their networks to address the growing bandwidth demands of cloud and streaming services.