Monday, October 22, 2012

Ciena Equity Analysis

The market didn’t take too kindly to the latest results from Ciena $CIEN but in a funny sort of way they were quite positive. I don’t think anyone can be excused for not knowing that global telecommunications companies have been lowering their capital expenditure plans this year so the weak guidance should have come as no surprise. However, the company did make a lot of positive noises about things improving in the second half in its last results commentary. As ever, analysts had priced this in only to be disappointed when reality hit home this quarter.

What Happened With Ciena’s Results?

Revenues of $474 million actually beat the mid-point of internal guidance of $455-485 million although the EPS loss was a tad more than estimated. No matter, it was the guidance for Q4 which caused the problems. The market had been looking for Q4 revenues of $499 million but Ciena guided towards $455-480 million. The mid-point of which represents a sequential decline. Moreover, the commentary around these results was saturated with the usual talk of macroeconomic issues and weakness in Europe. Network roll-outs are slowing and this is starting to hurt Ciena.

Non-GAAP Gross Margins disappointed again at 39.6% but the good news was that the higher margin parts of Ciena’s revenues saw a nice sequential gain. As such, management forecast that gross margins would get back to their targeted 40% in the next quarter. A look at revenues by product and service lines:

Software & Services and Switching are the higher margin business for Ciena and they seem to be on the upswing.

Another positive was that Ciena affirmed that there was ‘no backing off’ from the perspective of 100G deployment although the timing is obviously subject to questioning. This is good news for Ciena as it’s the leader in the 100G optical transmission gear market.

What is the Industry Saying?

I’ve covered this subject in more detail in an article linked here. Essentially, Verizon $VZ is determined to reduce capital spending as a portion of revenues and since it has already spent a lot of money on its 4G-LTE network, the pressure on capital spending growth is downwards. Verizon has been reducing its spending plans progressively through 2012. As for AT & T $T it has largely stuck with its spending plans and is expected to be increasing it in the second half. I think there should be question marks placed on this now. With 90% of its data traffic on enhanced backhaul already it is natural to think that expenditures might be reduced in the face of a slower economy.

In the conference call, Ciena argued that the major US operators hadn’t backed away from plans to update networks but this is not being seen in other companies that have reported. For example, Cisco Systems $CSCO reported flat revenues in switching in the last quarter and while the market warmed to its moves towards returning cash to shareholders there was little in the way of optimism on telco spending. Finisar $FNSR also gave disappointing results and talked of ‘sluggish carrier capital expenditure levels.’ Product sales for telecom applications decreased by 14.1% sequentially.

With all of this going on, it is puzzling why the market took Ciena’s downgrade so badly.

My only explanation is that the exposure to 100G and next generation networking gave the market some undue optimism that Ciena could avoid the woes of the sector. Some criticism could also be levied against the management for sounding so upbeat at the last set of results. The second half pickup doesn’t look like it’s coming in telco capex.

Where Next For Ciena?

The results had some more positive features to them than many may have supposed and the news that the telco’s are slowing spending is hardly surprising, so I think these results are not quite the disaster that the market move tells you they were. Longer term prospects look good for Ciena but the problem is that, as it has to wait for network roll-outs and next-generation telco spending to kick in, there is always the risk that competitors could play catch up. In addition, loss making telco stocks are hardly in fashion right now and the immediate outlook for telco capex is cloudy at best.

On a more positive note, the company is cash flow positive now and gross margins look set to improve. It’s the sort of stock that you want to be in when the carriers and service providers are reporting better prospects because it has the capacity to offer super industry growth. However, that time is not now and I think investors might want to be cautious here.