These Networking Stocks Are Worth a Look

Includes: CIEN, NPTN, OCLR
by: StreetAuthority

By David Sterman

T.S. Eliot once wrote that "April is the cruelest month." Yet a half-dozen companies that sell optical networking equipment would beg to differ: March has been quite cruel and they're hoping April will be far kinder.

The entire group rallied higher in the first week on word that Juniper Networks (NYSE:JNPR) would be ordering more optical networking gear to be used in its switches and routers. But my Monday, March 7, a raft of bad news would overtake the sector. That morning, Ciena (NASDAQ:CIEN) predicted sales in the upcoming quarter would take a hit, because customer orders had begun to slow and inventories of unsold optical networking components were piling up. Ciena, JDS Uniphase (JDSU), Finisar (NASDAQ:FNSR), Oclaro (NASDAQ:OCLR) and Oplink (NASDAQ:OPLK) all fell at last 7% that day.

The bleeding wasn't finished. Finisar weighed-in the next day, predicting sales in the quarter ended in April would lag forecasts, thanks to slowing customer orders. Finisar added the concern for much of the slowdown was coming from China, a market that was expected to account for major growth in 2011.Those same stocks that fell by high single-digits on March 7, all fell by double-digits the next day. The next few days weren't much better, and all of these stocks are off 30% to 60% since then.

Some industry watchers saw this coming. Demand for optical networking gear, which helps data traffic to move very fast through communications networks, soared 40% in 2010, according to industry research firm Ovum. Much of that growth was the result of customers stockpiling equipment to avoid being hit by any supply shortages. With key customers now sitting on ample amounts of unused equipment, a sales slowdown now seems to have been inevitable in hindsight.

Looking ahead
The quarterly slowdown increasingly looks to be the result of an industry with limited visibility, but the major customers for optical networking equipment are nowhere near the end of the line in terms of growth. In China, for example, where optical networking helps boost data transmission speeds, only 100 million handsets will be 3-G-capable this year. That's twice the amount of 2010 but still a faction of the 850 million handsets in use in China.

In the United States, the installation of optical networking equipment will remain crucial if carriers are to keep up with the exploding amount of data being consumed on wireless networks. That's not to say the industry will see an immediate bounce back. Analysts at Stifel Nicolaus figure the inventory overhang may stick around through the summer. The key for investors is to see inventories coming down and not wait until they have truly been worked though. When that finally happens, demand is likely to rebound for many of these firms and analysts will start to speak of that turn before it happens, implying share price rebounds ahead of a pick-up in demand.

Analysts at ACI Research think near-term inventory concerns are obscuring a larger brighter picture. They attended the annual Optical Fiber Conference (OFC), held earlier this month in Los Angeles, and noted that part of the slowdown is the result of key customers looking to step back and be sure they're keeping up with all of the industry's advances: "With advances come discontinuities. This heralds a tremendous amount of volatility for public companies. But make no mistake. It was the most exciting OFC in recent memory." (They're referring to the wide range of new products released at the show.)

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Names to own
Analysts at Auriga Securities think Oclaro will be the first to rebound, thanks to a range of newly-released products reaching customers in the spring. "The June 2011 quarter is pivotal for the company as new products including ROADM (reconfigurable optical add-drop multiplexer) and 40G transceivers." They see shares rising from a current $11 to $14.

Longer-term, shares could rebound back to the 52-week high of $19 because Oclaro has considerable exposure to the Chinese market: China's Huawei, the world's second-largest telecom equipment provider, accounts for 17% of Oclaro's sales, a figure that has been steadily rising in recent years. Another play is San Jose, Calif.-based Neophotonics (NYSE:NPTN), which derives 50% of sales from China. Shares of this early February 2011 IPO have already fallen by half from their peak.

Citigroup's analysts attended the same OFC conference and came away with their bullish industry view intact, despite the recent problems. They were particularly impressed with Ciena, predicting the company "will be a share gainer through the next cycle and expect to see a significant deal win over the next 90 days." They see shares rising from $24 to $34 in the next 12 months.

If you're a GARP (growth at a reasonable price) investor, you have to find high-growth industries that have become reasonably priced due to near-term growing pains. The optical networking stocks have plenty of room ahead of them, yet are currently being scorned while demand temporarily slows. As demand rebounds, so will these shares.

Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.