Sunday, January 6, 2013

Ciena Equity Research and Analysis

I often think that Wittgenstein was wasted as a philosopher. Of course he was born of a very wealthy family so he didn’t need to bother learning how to invest but, if he had, he would have loved the kind of philosophical puzzles that investors are faced with on a daily basis. These obscure thoughts came to my mind in considering the latest set of results from Ciena (NASDAQ: CIEN).

The Ciennese Waltz

Here is a company that misses estimates and guides the next quarter lower than existing consensus estimates while expressing a healthy degree of caution over analysts (positive) forecasts for growth in telecoms spending. Analysts then downgrade estimates and price targets. The stock goes up. Does all of this make sense?

Well as a matter of fact I think it does.

Essentially Ciena managed to eke out revenue and gross profit growth in Q4 and for the full year within declining end markets. It did this by winning market share and increasing diversification by developing sales within new markets. Ciena isn’t profitable yet but it did generate around $59 million in free cash flow and reported record orders for Q4. With orders totaling over $2 billion in 2012 and a current backlog of $900 million, the current analyst estimates of $2 billion in revenues for 2013 may prove a little light.

Ciena also claims to be benefiting from the trend towards network convergence. Indeed, starting from the next quarter it will report results within new segments that reflect this. Investors need to look out for this when modeling the company.

In summary, it is a story of execution within difficult end markets. Aside from convergence, the other big driver for Ciena will be the move towards 100G networking, within which it is well placed. Indeed, the company offers a compelling proposition because it does not have substantive legacy solutions that will drop out of the top line thanks to technological obsolescence. In other words, it’s a good stock to consider if you think there is upside to telco spending next year.

This Means Nothing to Me, Oh Ciena

The truth is that irrespective of how well Ciena is executing, if the telcos don’t pick up spending next year then investors will be disappointed. I’ve looked at the current situation in an article linked here and for a variety of reasons the big three have actually cut spending plans for this year. Of course, this turned out to be a bit of a letdown because the telco suppliers had been hoping for an increase in spending in the second half.

So why are industry analysts being so optimistic about 2013? And are investors setting themselves up for another disappointment?

The case for higher spending is based on an underlying assumption that telcos have been cautious on spending because of macro fears. However, the reality is also that pressure is building up thanks to increasing strains on capacity caused by things like rising smartphone penetration using bandwidth-rich applications. I’m sympathetic to this argument but consider it apposite to listen carefully to what the telco are saying themselves.

Sprint Nextel seems to be pushing some spending into next year while Verizon is making a virtue of reducing CapEx as a proportion of revenue going forward. The big hope lies with AT&T (NYSE: T), and it is talking up CapEx plans for the next few years. Happy days are here again? Perhaps, but at the end of the day it is still largely a macro call. The way to think of Ciena is as a leveraged play in growth that has its merits in its own right.

Markets and Competition

Ciena was clear on the conference call that it had been subject to pricing competition with rivals trying to take market share but, given that, Ciena actually increased their share. Moreover, when rivals like Inifinera (NASDAQ: INFN) make more positive noise on the pricing environment it suggests that conditions might be getting a little better for the industry. Infinera is predicting 10-20% revenue growth for 2013 with particular strength in 100G.

As for telco spending in general, Cisco Systems (NASDAQ: CSCO) also referred to better signs from US carriers, and I doubt anyone will get an earlier, more accurate read than Cisco. With that said, Cisco’s switching revenues have been very lumpy for the last year or so. They appear to have alternate good and bad quarters so it is hard to read a trend into them.

In general, most of the telco focused companies are talking about Europe remaining weak yet stable, but US conditions appear to be set to get better. Putting these things together suggests that telco spending overall can generate supra-GDP growth next year.

Where Next for Ciena?

I think the solution to this philosophical investment puzzle is to put Ciena in a class of telco stock alongside something like Acme Packet (NASDAQ: APKT)a stock discussed here, which also has technological leadership in an area of telco spending that is likely to be ramped up if/when telcos upgrade networks. APKT offers upside from the increased spending on voice over LTE while Ciena is strong in convergence and 100G networking.

They are probably the pick of the sector, and growth orientated investors who buy the telco spending recovery story will be well advised to take a look. However, as a GARP-based investor I would probably like to see some stronger evidence of increased telco spending first.