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.
Investopedia Broker Guides: Enhance your trading with the tools from today's top online brokers.

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.

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

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

Related Articles
  1. Stock Analysis

    Net Neutrality: Pros and Cons

    The fight over net neutrality has become an amazing spectacle. But at its core, it's yet another skirmish in cable television's war to remain relevant.
  2. Entrepreneurship

    Top 10 Side Jobs You Could Start Now

    Ways to make extra cash in your spare time.
  3. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  4. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  5. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  6. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
  7. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI USA Minimum Volatility

    Learn about the iShares MSCI USA Minimum Volatility exchange-traded fund, which invests in low-volatility equities traded on the U.S. stock market.
  8. Stock Analysis

    Should You Follow Millionaires into This Sector?

    Millionaire investors—and those who follow them—should take another look at the current economic situation before making any more investment decisions.
  9. Professionals

    What to do During a Market Correction

    The market has what? Here's what you should consider rather than panicking.
  10. Mutual Funds & ETFs

    ETF Analysis: Vanguard Mid-Cap Value

    Take an in-depth look at the Vanguard Mid-Cap Value ETF, one of the largest and most popular mid-cap funds in the U.S. equity space.
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Hard-To-Sell Asset

    An asset that is extremely difficult to dispose of either due ...
  3. Sucker Yield

    When an investor has essentially risked all of his capital for ...
  4. PT (Perseroan Terbatas)

    An acronym for Perseroan Terbatas, which is Limited Liability ...
  5. Ltd. (Limited)

    An abbreviation of "limited," Ltd. is a suffix that ...
  6. BHD (Berhad)

    The suffix Bhd. is an abbreviation of a Malay word "berhad," ...
  1. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  2. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  3. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  4. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  5. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>
  6. What happens to the shares of stock purchased in a tender offer?

    The shares of stock purchased in a tender offer become the property of the purchaser. From that point forward, the purchaser, ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!