Ciena Products in Demand by Telcos

Sep. 6.06 | About: Ciena Corporation (CIEN)

Investopedia Advisor submits: There are two big threats that telecom equipment makers need to worry about. The first is a slowing economy, and the second is consolidation. To be sure, both issues could stymie the equipment market. But does that mean you should avoid the group all together? Not at all.

Right now is a great time to do some research, because pretty soon I think the group will be ready for a run. And my favorite longer-term pick of the bunch right now is Ciena (NASDAQ:CIEN).

First off, for those who don’t know, Ciena makes the stuff that makes things like broadband services possible; things like amplifiers, splitters, filters, and routers. In the years to come, parts like these will be a necessity, as telco carriers build out their networks, and as new gadgetry is developed to keep us all “connected.”

Unfortunately, the market for telecom equipment has been a bit slow as of late. That’s because the big carriers spent a ton of money upgrading their systems in the late 1990s and early 2000s.

And the supply of infrastructure that was brought online essentially outstripped demand, but this is changing.

Telcos are competing like never before to offer improved products and services to their clients. And as a result, they are spending big money on the very parts that Ciena offers.

Of course, what investors need to understand is that this spending isn’t necessarily going to ramp up quarter after quarter and year after year until it goes to the moon. There will be bumps in the road and false starts.

What kind of bumps? As I mentioned in my opening paragraph, one of the biggest threats right now is industry consolidation. Why? Because as telecom carriers combine forces, one never knows what path the newly formed entity will take.

Will they concentrate on developing new products, or simply work to cut internal costs before seeking organic growth? Will the new company chose Ciena’s products, or will they pursue relationships with some of its competitors, such as Cisco (NASDAQ:CSCO), or Sycamore (OTCPK:SCMR)? These are the types of questions that lingered when Verizon (NYSE:VZ) and MCI, and SBC and AT&T (NYSE:T) teamed up. And it’s what is being talked about with the ongoing AT&T/BellSouth (BLS) saga.

My point is that trying to predict the short-term outcome of all of the possible combinations is almost impossible. There are so many facets to these deals that investors can potentially wring their hands over, including antitrust issues, a myriad of market conditions that may boost or thwart potential combinations, and altered equipment spending.

Suffice to say, if the hand wringers simply kept their collective eyes on the longer term ball, they would realize that over time consolidation will likely facilitate industry growth, as savings from cost-cutting are plunged back into the business. The equipment business will likely follow suit.

So, my thinking is this: Ciena deals with the major telcos. They have a terrific reputation in terms of their equipment quality. And going forward, they appear to have the capital and the manpower to drive sales, but with the caveat being that there can and will be bumps in the road.

Again, I feel that waiting for all of the potential consolidation to get out of the way before jumping in is ridiculous. As a result, I think one has to look at it and say that when the dust settles, the demand for the company’s wares will most likely increase over time, and then base investment decisions from there.

Another big concern as I mentioned is an economic slowdown. I mean, think about it. If the economy tanks, consumers might not want to plunk down $30 or $40 a month for a high speed Internet connection or other gadgets. As a result, telco spending may wane, but, based upon current economic conditions, I am not too worried.

Hold the email folks! Like I said, I totally see the risk of slower consumer and corporate spending. But, look what is happening all around us. Look at how communication methods and devices have improved worldwide over the past two decades, in spite of some difficult economic times (such as the late 80s or post 9/11). Then look to what the telcos are seeing.

For example, Verizon just added 440,000 broadband connections in the second quarter alone. It also was optimistic on its ability to improve revenue going forward, and has, to that end, put its money where its mouth is by repurchasing shares in the open market. My point is that while there could be a near-term downtick to spending, I think that the telcos and the equipment makers will continue to flourish over time.

Ciena sports about $1.57 a share in cash, and is teetering on the edge of profitability. And when the company can prove to Wall Street that it can turn in consistent profits, I think the stock will run. When will that happen? In 2006, analysts peg the company to earn a penny or two per share. And in 2007, Wall Street puts earnings at 10 cents a share. So, this is not an earnings play yet, but I think it will be in a few years. And if the company can string together a couple of profitable quarters, which I think is doable in the coming year, I can’t help but think the shares will respond in kind.

With all of that in mind, if I wasn’t already positioned in the stock, I would wait until year end. Why? Although the company beat estimates in its third quarter, released last week, management suggested that revenue growth would increase by only about 5% sequentially in the fourth quarter.

That is well below the double digit-growth it showed in the third quarter. As a result of this “downtick” in revenue growth, I think there could be some tax loss selling that could drive the shares down further.

The other risk is one of perception. In conjunction with Ciena’s earnings announcement, the company announced plans to enact a 1-for-7 reverse split, which should go into effect on September 22. There is some thinking that the reverse split, since it will adjust the share price higher (as shareholders will have fewer shares), will make the stock more attractive to buy-side institutions.

I generally agree. However, there is this perception on Wall Street that a reverse split, no matter what the reason, is a bad thing. As a result, I would prefer to wait to see how investors react to the split before jumping in full-force.

In short, Ciena is a solid company with good growth prospects. In my mind, it is now a question of picking an appropriate entry point.

CIEN 1-year chart:

By Glenn Curtis, Contributor - Investopedia Advisor

At the time of release Glenn Curtis owned shares in CIEN.