Microsoft's (NASDAQ:MSFT) comments regarding DCI (data center interconnect) solutions during the optical industry's annual OFC conference recently boosted shares of Inphi (NASDAQ:IPHI) and Ciena (NYSE:CIEN) while punishing shares of Infinera (NASDAQ:INFN). Let's take a closer look at what Microsoft said, and how those three companies were affected.
The business of DCI solutions
To understand how Microsoft influenced those three companies, investors should first understand the market for DCI solutions, which extend the benefits of multi-tenant private clouds across multiple data centers. These solutions improve near real-time disaster recovery and business continuity between data centers, and rely heavily on high latency connections. According to IDC, large enterprises mainly deploy DCI solutions for more efficient IT resource utilization, better end-user access for applications, and simplified data center management.
Research firm Ovum believes that the global DCI market will grow at a compound annual rate of 10.5% between 2014 to 2019 into a $4.2 billion market. Since Microsoft has a massive presence in the enterprise market with its private, hybrid, and public cloud platforms, it was widely expected to be one of the largest purchasers of dedicated DCI boxes.
What Microsoft said
Yet during the OFC conference, Microsoft unexpectedly declared its preference for "short-reach" (less than 80km) data center DCI modules which are built directly into Ethernet switches, instead of stand-alone DCI systems like Infinera's Cloud Xpress and Ciena's Waveserver. Furthermore, Microsoft unveiled a new module co-developed with Inphi which plugs directly into data center switches, completely eliminating the need for dedicated DCI boxes.
That was bad news for Infinera, which had expected Cloud Xpress to become a major source of revenue as major web and cloud service providers upgraded their data center infrastructures. Last quarter, the company claimed that it had 20 Cloud Xpress invoice customers, including a "number" of big Internet firms. Unfortunately for Infinera, it doesn't look like Microsoft will join that list.
Microsoft's declaration was also bad news for Ciena's Waveserver, but a large percentage of Ciena's sales actually come from packet-optical systems which add short-reach DCI functions to Ethernet switches. Based on Ciena's subsequent rally, investors apparently believe that growth will offset any softness in its stand-alone DCI system sales.
Was Infinera unfairly sold off?
Infinera shares fell as much as 10% on March 22 after Microsoft's announcement, but the stock has since recovered some of those losses. JPMorgan analyst Rod Hall calls the pullback a buying opportunity, claiming that the range of "direct detection" technology still remains too short and will eventually require dedicated DCI boxes.
Jefferies analyst George Notter admitted that the partnership between Microsoft and Inphi "sounds scary" for Infinera's DCI business, but noted that it will take some time for Microsoft and Inphi's short-reach solution to reach 80km distances. Notter believes that the shift might cause Infinera's Metro DCI business to lose $20 million in fiscal 2016, which would account for just 2% of its projected revenue. Notter also points out that both Infinera and Ciena still have growing customer lists of stand-alone DCI customers.
Last quarter, Infinera's non-GAAP revenue surged 40% annually to $260.6 million and beat estimates by $1.8 million. Product revenue rose 43% annually to $227 million, thanks to the acquisition of Swedish optical networking hardware firm Transmode, while services revenue climbed 19% to $33 million. Non-GAAP earnings per share rose 62% to $0.21 per share, topping expectations by a penny. Those numbers indicate that demand for the company's optical transport networking equipment and services remains robust. Moreover, analysts still expect Infinera's earnings to grow 15% annually over the next five years.
The valuations and the verdict
Despite those positive numbers, I think investors should stay away from Infinera, which could be crippled by a tectonic shift in technological tastes among the major cloud providers. Considering that Microsoft is the second largest public cloud provider in the world after Amazon, investors shouldn't ignore the possibility of other cloud giants following Microsoft's lead. If that happens, short-reach DCI players like Inphi and Ciena could post stronger growth than Infinera, which might be placing too much faith in stand-alone DCI boxes.