It's important to remember that there are multiple definitions of success out there. Some companies have very successful products, but that doesn't always translate into impressive financial results or outsized stock market performance. Although EXFO (Nasdaq:EXFO) has been quite successful in terms of market and technology leadership in the communications testing business, management has never really translated that success into impressive financial results.
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More of the same in Fiscal Second Quarter
Performance has been tough at EXFO for a while now, as major carriers like Verizon (NYSE:VZ) and AT&T (NYSE:T) delay capital spending on their networks. Although EXFO had established a recent string of squeaking by the quarterly expectations but lowering forward looking numbers, this quarter featured both a miss and yet another takedown of guidance.

Revenue dropped 7% this quarter and while disappointing, at least they're doing relatively better than other carrier-exposed names like JDSU (Nasdaq:JDSU), Alactel-Lucent (NYSE:ALU) and Powerwave (Nasdaq:PWAV). Gross margin actually improved (up more than three points), but operating income dropped about 40% as the company maintained its spending in marketing and research and development (R&D). For more information, see The Ins and Outs Of In-Process R&D Expenses.

The Build-Out will Come ... Eventually
EXFO did report a 5% increase in bookings, but nobody seems all that optimistic about the near-term outlook for North American carrier spending. The ongoing 4G build-out means that these carriers will eventually have to spend the money, but nobody seems to know when that's going to materialize. Moreover, given the increasing demands on network capacity from smartphones and tablets, to say nothing of the complexity of operating multi-generational networks with disparate equipment, test solution equipment demand should pick up ... eventually.

Luckily for EXFO, they can afford to wait. The company has a clean balance sheet and is still profitable. Moreover, the company has a long (albeit not perfect) record of staying free cash flow positive despite the vagaries of the market.

Can Management Marry Market Excellence with Better Financial Numbers?
According to Frost & Sullivan, EXFO is No. 1 or No. 2 in almost all of its markets, with leadership in areas like portable fiber optic test equipment and ODTR. While Agilent (NYSE:A) and Danaher (NYSE:DHR) are bigger overall in electronic test equipment, they're not so focused on the wireless or wireline equipment market, and JDSU is more of a head-to-head competitor.

Excellence in the field hasn't meant excellence in the financials. EXFO's long-run free cash flow conversion performance is weak, and the company's returns on capital have been unimpressive. While some of this can be blamed on the high ongoing R&D investments the company makes, sooner or later market leadership has to translate into meaningful economic returns to be worth something to investors. To learn more, see The Cash Flow Statement.

The Bottom Line
I wouldn't throw in the towel just yet on the idea of EXFO delivering better financial performance. I do see the possibility of strong incremental margins and better profitability (as well as free cash flow and returns on capital) if carrier spending takes off like most analysts expect it will.

That said, the market already seems to be expecting a better performance. I find it irksome that my estimate of fair value ($8) largely matches the current average sell-side target price, but I do acknowledge that markedly better incremental margins could offer some upside. Nevertheless, with so many other cheaper stocks out there, I'm not sure stepping up and buying EXFO makes the most sense today.

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.