sbelov
For what small comfort it offers, Ciena (NYSE:CIEN) has been among the better networking names since my last update, with the roughly 7% decline in the share price still better than the performance of a broader group of peers including Cisco (CSCO), Infinera (INFN), Juniper (JNPR), and Nokia (NOK), while Arista (ANET) and Lumentum (LITE) have done slightly better.
This underperformance can be tied back to the supply chain and component availability issues that are affecting the entire sector, reducing companies’ ability to ship to demand and weighing heavily on margins. Not only that, some of the bloom is coming off of key end-markets, as spending from cable, cloud, and telco providers seems likely to slow in 2023.
Against that perhaps gloomy backdrop, I still see an argument for owning Ciena shares. The company has about a year’s worth of revenue in its backlog and I believe the company has passed at least the halfway point in its supply challenges. Moreover, as the company gains share from Huawei and sells follow-on products into its base, I see more room for margin expansion. Priced for a double-digit long-term annualized return, I think this is a name to consider, albeit with some elevated near-term (two or three quarters) risk remaining.
Heading To The Bottom
While I do believe there could be some elevated volatility in results for at least a few more quarters, I believe Ciena is heading toward the bottom of this particular cycle. Orders have remained strong through this challenging period, with healthy demand from telco, cable, and enterprise customers, but Ciena has been unable to ship to demand and has taken a noticeable hit to margins in the meantime (last quarter’s gross margin was down almost six points, with a nearly eight-point hit to product gross margin).
I believe the next quarter, the fiscal third quarter that should be reported in early September, will mark the worst of the cycle for margins, and possibly the bottom for revenue as well, though I’d note that the fiscal first quarter is usually seasonally weak, so there could be some risk there.
I expect a roughly 7% year-over-year decline in revenue (the Street is closer to 8%, with a Street low of 10%) with a little more risk to the product revenue lines. Routing and switching should be relatively strong, but optical will likely see more pressure.
As seen with Cisco’s (CSCO) recent report and commentary from other companies in the sector (broadly defined), component availability remains a significant issue. Companies are turning to brokers to get what they need and paying premiums to do so, and this is likely to continue a little while longer. I do see a risk of Ciena’s gross margins declining to around 42% (from 43% in FQ2 and 48.5% a year ago), but I think that could be the bottom. The supply chain pressures are still going to be present for a few more quarters, but I think the negative impact will start to lessen.
What’s arguably more important about the coming quarter is management’s commentary. A couple more bad quarters are already in investor expectations, but I think the Street needs to hear a few things to walk away feeling better. First, orders need to remain healthy – not necessarily as strong as the last quarter (where the book to bill was around 1.5x), but still growing. Second, there needs to be some near-term improvement in the company’s ability to deliver on the backlog. Third, and probably most risky, I think the Street needs to hear that there are some signs of improving component availability, or at least visibility to improvement in 2023.
Storm Clouds On The Horizon
The comparability between Cisco and Ciena is always limited, but I think the 6% decline in product orders in Cisco’s recent quarter (against a +31% year-ago comp) will be on investors’ minds going into Ciena’s quarter.
Enterprise demand has been surprisingly healthy, and I do think that Ciena still has an attractive webscale opportunity, but one where share gains are likely going to get harder to achieve. On the other hand, I do have some concerns about cloud capex spending. With the shift in sentiment in the tech sector, investors are placing a greater emphasis on profitability among SaaS companies, and I’m concerned that this could drive some deceleration in spending next year – the Tier 1 customers are likely to be fine, but I’m thinking more of Tier 2 and Tier 3.
I also expect some slowdown in telco and cable company capex next year. Offsetting this, at least in part, is a significant ongoing opportunity to leverage 5G spending over several years, as well as an opportunity to gain share at Huawei’s expense and grow share in Europe in particular.
The Outlook
It’s my belief that Ciena isn’t really losing out on many revenue opportunities, but rather is seeing those opportunities pushed out some as customers slow their capex investments and as component shortages reduce the company’s ability to ship to demand. That said, the company is losing out on near-term profitability due to the higher costs, and that does impact valuation.
Relative to my last update, I’ve taken my FY’22 revenue estimate down by about 6% and my FY’23 estimate by about 3%. As I said, I think Ciena ultimately gets most of this back, just a little further down the road.
With margins, there’s no question that higher input costs are impacting margins and will continue to do so for a while longer. Longer term, though, I do expect to see the component situation normalize, and Ciena will also be poised to benefit from selling higher-margin line-cards into the lower-margin cases it has been selling in recent quarters. Longer term, I’m still expecting over 6% annualized revenue growth and 8% annualized FCF growth from Ciena.
The Bottom Line
Between discounted cash flow and a margin/return-driven EV/EBITDA, I believe Ciena shares are undervalued, with FCF supporting a long-term annualized total return in the low double-digits and an EBITDA-based fair value in the mid-$60’s (13.5x FY’23 EBITDA). I do still see some near-term risks to sentiment, particularly if the next quarter or two sees management getting more cautious on end-user demand and/or a resolution of component shortages. Still, even with those risks, I think there is more than enough upside to argue for owning Ciena today.
