I realize that many readers have little or no sympathy for sell-side analysts, but I don't envy them the task of figuring out the telco capex space these days. JDS Uniphase (Nasdaq:JDSU) and Oplink (Nasdaq:OPLK) recently offered solid beat-and-raise quarters that stoked hopes that the much-awaited carrier spending rally has finally come. And then along comes Ciena (Nasdaq:CIEN); a company that has been introducing solid technology and gaining share, but sees less strength in the market right now. As befits its space, Ciena is a tough stock to figure out. While much more promising (and not nearly so beaten down) than Alcatel Lucent (NYSE:ALU), Ciena has to start delivering pretty substantial profit improvements for the stock to really work. The potential is certainly there, but then so are above-average risks as well.
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Fiscal Third Quarter Results were Solid ... ish
Ciena actually did alright with respect to expected fiscal third quarter earnings. Revenue rose 9% from the year-ago level, while sliding about 1% from the prior quarter. Switching was the leader in sequential growth (up 22%), while transport saw sales down 6% sequentially. Curiously, the performance was flipped on a year-on-year basis (switching was down 7%, while transport was up about 2%).
Like revenue, margins were OK relative to expectations, but not especially impressive on their own. Gross margin (whether GAAP or non-GAAP) fell more than four points from last year and was basically flat sequentially, with service margins not really helping much and the company likely seeing some help from switching. On a GAAP basis the company is still in the red on the operating line, while non-GAAP operating income slid about one-quarter on a sequential basis, but basically met margin expectations.
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And Then There's the Guidance
Unlike JDS Uniphase, Oplink and even Nokia-Siemens Networks, management wasn't too chipper about the near-term outlook. Ciena management cited well-known macro issues, but also delays in deploying projects that the company had previously won. It's hard for me to know what to make of this. I think the company has a great opportunity in 40G/100G upgrades at customers like AT&T (NYSE:T), Verizon (NYSE:VZ) and Comcast (Nasdaq:CMCSA) and I think the company is taking share from the likes of Alcatel Lucent.
At the same time, though, particular projects/installations/rollouts can certainly get delayed and it seems that customer/product/project mix matters more than ever before. In other words, don't be surprised to see Company A have a bad quarter while Company B has a good one ... only to see it reverse in the next quarter or two.
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The Bottom Line
I'm attracted to what I see as superior technology at Ciena and the opportunity to prosper with new product and technology launches. What's more, I think carriers have been under-spending relative to their ongoing long-term capex needs, and that that cycle has to reverse at some point. In many respects, then, I can see how Ciena continues to work as a turnaround/rebound play. But there's definitely a down side as well. Alcatel Lucent, Nokia-Siemens and Huawei aren't going to surrender the field and the threat of price-driven competition shouldn't be ignored. The company also has a pretty hefty slug of debt - $1.4 billion in convertible debt (roughly $900 million net) that could translate into 55 million potential shares.
Estimates are all over the place on this stock. While I believe Ciena can grow its revenue by almost 50% by 2017 (to over $2.6 billion) and improve its free cash flow conversion into the mid-single digits, that's only good for a fair value around $14 if you exclude the debt (and $4 if you include it). On the other hand, some analysts believe that Ciena can approach $3 billion in revenue in 2017 with a free cash flow margin in the low teens. Bake the cake with that recipe and you can get a fair value (including the debt) of $22 per share.
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Clearly, then, the investment case on Ciena depends hugely on the company's ability to boost operating margins and continue winning share with carriers. If you're bullish on the company's margin leverage (or want a leveraged play on carrier equipment demand growth), this stock can definitely work from here.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.