As much as I've thought (and written) that Ciena (Nasdaq:CIEN) was a good way to play the eventual recovery in carrier spending, I couldn't personally get comfortable enough the long-term financial numbers to buy the shares for myself. While that didn't seem so bad over the recent months as the shares lagged the broader market, today's big reaction to second quarter earnings is a little hard to swallow for those of us on the sidelines. The good news, though, is that it really does seem like carrier spending has come back, and with that Ciena shares still look underpriced.
A Strong Second Quarter On Multiple Fronts
Ciena reported that revenue rose 6% for the second quarter, good for a 5% beat relative to Street expectations. Growth was led by converged packet-optical (up 10%) and packet networking (up 91%), while optical transport (down 32%) and software/services (up 3%) were less helpful.
Margins are a critically underappreciated part of the carrier equipment cycle story, and Ciena is coming along well here. Gross margin improved about three points from last year, with product margin up above 43% again. Operating income rose 14% for the quarter, blowing away the Street average estimate by more than 60%.
SEE: Analyzing Operating Margins
Carriers Are Coming Back, And The Cycle Should Just Be Starting
I think it's important that AT&T (NYSE:T) and Verizon (NYSE:VZ) combined for more than 30% of Ciena's sales this quarter, as it suggests year-over-year growth in excess of 30% and 20%, respectively. There has been a lot of debate about the timing and magnitude of the carrier spending recovery, with every earnings report, conference presentation, or sell-side report on Alcatel-Lucent (NYSE:ALU), Ericsson (Nasdaq:ERIC), Cisco (Nasdaq:CSCO), Juniper (Nasdaq:JNPR), or JDSU (Nasdaq:JDSU) moving the needle across the investor sentiment dial.
With this growth from Verizon and AT&T, as well as past turnkey and product wins with CenturyLink (NYSE:CTL) and Comcast (Nasdaq:CMCSA), it's incrementally easier to feel better about Ciena and the carrier spending environment. The shift to OTN should be a multi-year revenue opportunity, particularly as the shift towards datacenters and public clouds creates even more (and different) carrier network traffic. Over the next five or so years, it is estimated that spending on optical systems and OTN switching will grow from over $10 billion to over $20 billion – creating a very real market opportunity.
Competition And Margins Still Matter
While the revenue opportunity is there, the timing, magnitude, and profitability of the opportunity is still very uncertain. Ciena was a first-mover in 100G (expected to post a 40%+ CAGR over the next five years), but Infinera is competing hard for this business, and Alcatel-Lucent isn't giving up either. It will be interesting to see how Alcatel-Lucent goes for this business, as the company's still-difficult long-term liquidity situation would suggest that protecting margins is pretty important.
Investors should also not underestimate the threat from Cisco, which has been increasing its focus and market presence in the optical market. Last and not least, Huawei remains the global market leader with almost one-quarter share, but recent moves in the U.S. and Europe to restrict the participation of Chinese telecom equipment providers ought to be a positive development on balance for Ciena.
While I like Ciena's technological and competitive positioning, timing and margins are still looming as large unknowns. The apparent jump in business from AT&T and Verizon this quarter is certainly encouraging, but it wouldn't be unprecedented to see lumpy spending from here on out. Moreover, it sounds like carriers are being quite a bit more disciplined than in past cycles, and that may stretch out the cycle longer than analysts and investors currently expect.
It will also be vital for Ciena to continue to show positive margin development. Ciena's margin structure is a competitive advantage against Alcatel-Lucent, but there have been recent discussions of more aggressive pricing in the 40G/100G market (not necessarily from Alcatel), and I don't want to dismiss the risk of “profitless prosperity” where companies sacrifice margin for market share.
SEE: A Look At Corporate Profit Margins
The Bottom Line
Even with the big post-earnings move in the shares, I believe Ciena remains underpriced. I believe the company will post a revenue CAGR of around 7% to 8% over the next decade. At the risk of being tedious, margins remain the big unknown. For now, I'm assuming a long-term free cash flow (FCF) margin in the 10%-11% area, which suggests free cash flow growth in excess of 20%. While 10% is not all that great for communications hardware, it's better than Ciena or most of its peers have managed in a very long time.
All told, I think Ciena is worth about $22 today. That makes the stock worth considering here in the $18's, and particularly interesting if it should slip back closer to the mid-teens.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.