With Cisco (Nasdaq: CSCO), Juniper (Nasdaq:JNPR), and Ciena (Nasdaq:CIEN) all having decent enough recent quarterly reports, things were set up for Finisar (Nasdaq:FNSR) to do pretty well this quarter. Luckily, the company delivered, as strong datacom sales offset ongoing weakness in telecom. There is plenty of controversy around this name – ranging from customers self-sourcing components to the threat of silicon photonics – but the current stock price doesn't appear to capture all of the potential over the next two or three years.
Data Delivers For The Fiscal Fourth Quarter
Finisar's fiscal fourth quarter was one of those “best of times, worst of times” propositions. Although telecom remains stubbornly weak, an upgrade cycle in data center optics helped deliver a good quarter.
Revenue rose 2% both on a sequential an annual comparison, with datacom delivering 11% sequential growth against a 12% decline in telecom. While datacom has historically been about 55% to 60% of the business, that percentage has jumped up past two-thirds as the datacom upgrade cycle boosts sales and the telecom recovery proceeds slowly. Margins improved nicely this quarter, with gross margin up 150bp sequentially and operating income up 15%.
No Telco Recovery Until Later This Year?
Although Ciena was relatively constructive on an improving environment for telecom carrier spending, Finisar management seems to think it won't occur until late in 2013 or early in 2014. While that's not really that much different than Ciena's viewpoint, I think it's also worth considering that Finisar is more exposed to Alcatel-Lucent (NYSE:ALU) than Ciena, and their struggles may be factoring into that guidance. As it was, sales of WSS and ROADM cards were flat for the quarter and tunable XFP sales were down about 10% from the prior quarter.
SEE: Will A New Alcatel-Lucent Plan Lead To Better Results?
Datacom Safe For Now, But What About The Future?
There seems to be no shortage of worry about the safety/sustainability of Finisar's datacom business. In the near-term, bearish analysts and investors believe that the company will suffer from Cisco going with internal sourcing in 100G, though the apparent strength in 10G and 16G is mitigating that risk to a large extent today.
Then there are the worries about silicon photonics. Both Mellanox (Nasdaq:MLNX) and Avago (Nasdaq:AVGO) have made acquisitions in this space (Kotura and CyOptics, respectively), and the fear is that these products will either displace Finisar's components or lead to severe price erosion. I'd be patient – while I do have concerns about the long-term sustainability of the improvements in datacom and telecom (whenever that starts...), I think Finisar can withstand this silicon photonics threat.
Can The Rebound Lead To Something More Enduring?
Finisar's 10-year financial history is not great. There has been minimal net free cash flow generation, poor returns on capital, and only recent signs of operating leverage. So while revenue has grown nicely (about 20% on a compound basis) and the company holds the leading share in the optical components space, it's fair to ask what that is all worth.
I do believe the company's products in ROADM and tunable XFP could grab some more share from JDSU (Nasdaq:JDSU), and that could likewise help the company grow with customers like Ciena (not to mention Cisco and Huawei). For better or worse, though, Finisar also needs to see customers like Brocade (Nasdaq:BRCD) and Alcatel-Lucent get their act together. I'm not so optimistic on that front, as I think Alcatel-Lucent's prospects in optics will worsen due to the likes of Ciena.
The Bottom Line
Like Ciena, I believe there is still time to buy these telecom equipment stories. As this quarter demonstrates, Finisar is definitely benefiting from a datacenter upgrade cycle, even while overall enterprise IT spending isn't very good. Add potential rebounds late this year or early next year in enterprise IT and telecom, and things could get interesting for the next year or two.
I think Finisar is worth about $18 today on the basis of long-term sales growth of about 8% and free cash flow growth in the high teens. I'm very nervous about that second projection, as there is no track record here to suggest that Finisar can attain, let alone maintain double-digit free cash flow margins. On the plus side, cash flow barely registers on many tech investors' radar screens, and the EV/sales ratio is not demanding at all at today's level.