Ciena: Best-Positioned To Ride The Longer-Term Optical Growth Story – Seeking Alpha

As Ciena's (CIEN) Q3 results showed, having a business built around a few key customers has its drawbacks. Despite increasing diversification across its client base, a spending pause at its major telco clients looks to have significantly de-rated shares, driving a discount to the multiple despite its long-run growth outlook remaining largely intact. Looking through a softer Q4 guide, I remain bullish on the long-term potential, with growth tailwinds across optical, share gains from Huawei restrictions, and operating leverage set to drive continued earnings growth.

On a non-GAAP basis, Q3 revenue reached $976.7 million, with telecom revenue declining 3% Y/Y to $556 million. Non-telco revenue offset this weakness, rising to a c. 43% contribution for the quarter, led by Webscale, along with both MSOs and R&E/enterprise customers. By region, the vast majority (c. 70-75%) of Ciena sales still come from the Americas, with a lower level of deployments in India (as a result of COVID-19-related lockdowns), weighing on the overseas contribution.

(Source: Ciena Form 10-Q)

Gross margins were, however, a positive surprise for the quarter at 48%, well above the prior 44% to 46% guidance range. The margin improvement reflected a favorable mix shift toward line card additions into existing systems, which carry a better gross margin profile. A decrease in operating expenses also played a key role, coming in below consensus estimates despite a Q/Q increase in headcount for the quarter. As a result, Q3 EPS of $1.06 was well above consensus.

(Source: Ciena Q3 Presentation)

Encouragingly, management confirmed on the Q3 call that there are no cost-cutting plans at this point, even though fiscal 2020 is set to see materially lower opex due to COVID-19. Interestingly, management also noted that logistical challenges have played a key role - COVID-19 is making it more difficult to access deployment sites and install equipment, and as a result, customers are opting to defer larger new deployment projects.

Top-line guidance for the upcoming quarter stands at $820 million at the midpoint of the $800 to $840 million range, well below consensus expectations. In addition to slower roll-outs of optical technologies, and challenges in India as a result of COVID-19 restrictions, management also attributed the weakness to a slowdown in carrier spending amid weaker enterprise activity. In particular, order weakness seems to have accelerated in the quarter, with management expecting peers with similar exposures to note similar headwinds later in the Fall.

(Source: Ciena Q3 Presentation)

Considering capital expenditure plans at major US telcos such as Verizon (VZ) and AT&T (T) are slowing heading into the second half of the year, the Q4 weakness makes sense in context. Aside from COVID-19-related headwinds in the telco business, the CBRS and C-Band wireless auctions, which have led to spending with Ciena being front-loaded in the year, likely played a part as well.

Ciena remains in pole position in 800G, although peers such as Infinera (INFN) are nipping at its heels. With a growing number of wins and an impressive list of trials, Infinera, for instance, appears to be getting close to its 800G rollout as well. There have also been reports of Verizon testing Infinera, which has led to speculation of a potential transition away from Ciena. However, there are high switching costs, and any transition will likely prove to be gradual.

For now, I think Ciena is well-positioned, having secured 50 design wins for WaveLogic 5 Extreme and shipping over 1,000 modems to 40 customers globally within months of commercial availability. The current slowdown is more skewed toward operationalization, which has been impacted by COVID-19. But RFPs have not slowed down, which is a key positive.

There is also a major opportunity for Ciena to gain share at the expense of Huawei, especially in Europe - Huawei held a c. 30% market share in the region pre-COVID-19. As many European countries move away from Huawei, however, there should be plenty of business up for grabs, and Ciena, as the market leader, is well-positioned to benefit. However, any share gains will likely be gradual - as management outlined, replacing an existing vendor, especially a major one, is a multi-step process involving extensive qualification and back-office integration testing, among other steps.

Source: Ciena Q3 Presentation

On balance, I believe Ciena remains the best play on the optical theme over the long term. With newer wins such as CenturyLink (CTL) and Windstream (OTCPK:WINMQ) yet to meaningfully contribute, there is still upside to earnings ahead, despite the near-term demand weakness from telco and webscale customers.

Pending a faster than expected recovery at key customers or signs of an accelerated Huawei displacement, the near-term outlook is admittedly cloudy, but this appears to be well reflected in the price at c.13-14x fiscal 2021 EPS. With the underlying longer-term growth potential largely intact, however, I believe shares should trade at a premium to peers instead. As such, I see current valuations as a buying opportunity.

Data by YCharts

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Ciena: Best-Positioned To Ride The Longer-Term Optical Growth Story - Seeking Alpha