Ciena Corp (CIEN)

[chmcnfunds]

Ciena Isn't Done Yet

Dec 12 2013, 14:20 | 4 comments | about: CIEN

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)

Optical telecom equipment maker Ciena (CIEN) has pulled back, and it's time to consider buying the dip.

"Wait for a pullback" and "buy on a dip" are some of the most hackneyed pieces of investment advice out there, and there's often an important detail missing. While it often does make a great deal of sense to buy good stocks on a momentary setback, what investors are seldom reminded of is that buying on these occasions often requires a lot of fortitude. After all, there's usually some near-term reason why the shares are trading down and climbing aboard a stock just as it is careering off a cliff is an experience that sticks with you.

Ciena has certainly seen the pace of sales growth and margin improvements slacken, but I believe this will prove to be a pause that refreshes. There still seem to be long-term legs to the equipment/network upgrade cycle, and Ciena has reemerged as a share gainer in the space. Investors can't ignore the risk that 2014 sees sales growth slow after the double-digit growth in fiscal 2013, but the valuation here is appealing.

Beat-And-Lower Sours The Street

After a major rally during the summer and fall, Ciena shares had backed off about 20% as analysts started fretting that Verizon (VZ) was going to cut back spending on 100G deployments in the aftermath of its deal with Vodafone (VOD). There was also some buzz that signs of stability at Alcatel-Lucent (ALU) could strengthen that company's competitive positioning.

As it turns out, Ciena did in fact deliver the beat-and-lower quarter that some analysts had forecast. While revenue was up 25% yoy (and up 8% sequentially), investors were less interested in the 3% beat than in the roughly 2% shortfall in management's revenue guidance for the January quarter.

It's also worth noting that Ciena's margins were lower than forecast, but I have a bone to pick here with the Street. Adjusted gross margin did fall two points from last year and almost three points from last quarter (with product gross margin down a similar amount), and that was about 150bp below Street forecasts. Here's the thing that irks me - it was already known that Ciena had won some large converged packet optical deals, and those deals typically have low(er) gross margins on rollout and better margins down the line as customers add features and additional capacity. In any case, operating profits did fall more than one third from the prior quarter, with an operating margin of 5% for the quarter.

How Long Will Verizon/AT&T Hit The Pause Button?

Based on management's comments, it sounds as though both Verizon and AT&T (T) slowed their spending in this quarter. Between the announced deal between Verizon and Vodafone and the strong pace of order/sales growth over the past year, I can't say it's a huge surprise.

Now the question is how long it will take Verizon and AT&T to resume stronger orders. If Verizon is only pausing for reasons tied to the Vodafone transaction, I would expect orders to start improving in a couple of quarters. If it's more of a case of slowing overall deployments and reevaluating where they sit with respect to long-term plans, there is a risk that the spending delay could stretch into 2015.

It's true that Ciena is not just a Verizon/AT&T story. Ciena has over 40 100G customers, including companies like Comcast (CMCSA) and Reliance, and Ciena has been pushing hard to get more traction with Web 2.0 and cloud datacenter customers. Even so, it will be challenging for the stock to make a lot of headway if analysts and institutional investors are scared that the two biggest customers are curtailing their plans or entertaining alternatives from Huawei, Cisco (CSCO), Alcatel-Lucent, and/or Infinera (INFN).

Gaining Share And Standing Apart

Ciena runs second to Huawei in most markets where they compete, but Ciena has been shrinking the gap some in recent quarters. Huawei has started to get more rational on pricing, which has benefited Ciena. The company has also won deals from new customers (new to Ciena, that is) at the expense of Huawei and Alcatel-Lucent, apparently due both to a perception of better technology at Ciena and concerns about the long-term viability of Huawei and Alcatel-Lucent as suppliers (security risks for the former and balance sheet risks for the latter).

Ciena does have something to offer customers in its optical products. The company has stood apart with its control plane software, improved software and DSP capabilities, and better product integration. At the same time, while would-be rival Cisco works to integrate more optical transport capabilities into routers, Ciena has been taking advantage of the lower overall cost of optical systems. Elsewhere, Ciena has also been picking up meaningful share in the ultra-long-haul transport market, largely at the expense of Alcatel-Lucent, and rebuilding some of its share in ROADM.

The Bottom Line

The switch to 100G and general upgrade cycle in optical equipment isn't going to go on forever. There will certainly be some timing differences as Ciena customers upgrade at different rates, but this isn't likely to be a "buy and hold forever" stock. At the same time, I think it's premature to say that the upgrade cycle is over and that Ciena is now destined to go back into hibernation to await the next cycle.

I'm still looking for "high mid" single-digit long-term revenue growth, with a meaningful improvement in free cash flow margins as Ciena builds on those lower-margin initial deployments. Even with an elevated discount rate, that suggests a fair value in the neighborhood of $24.

Given that I feel my estimates are more likely to fall of the conservative side, I'm strongly considering buying this dip. Ciena is going to be a stock with above-average volatility, with reports, guidance, and commentary from the likes of Cisco, Juniper (JNPR), JDSU (JDSU), Infinera, and Finisar (FNSR) moving the shares between earnings. Even so, I think there's reasonable compensation for that volatility and I'd suggest taking a closer look at Ciena while the Street is turning away.
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