Ciena's Earnings Show Bandwidth Demand Strong

Ciena reported first quarter financial results this morning and on the surface earnings and revenue growth appeared strong. Compared to the year ago period, revenue rose 37% to $165.1 million versus $120.4 million last year. Profits totaled $11.1 million for the quarter or 22 cents per share, reversing a year ago loss of $6.3 million. Despite the seemingly strong quarterly report, shares of Ciena were down over 10% in early trading at $28 a share.

Typically when a company has a relatively good earnings report, but the shares drop, it is due to negative guidance. This does not appear to be the case for Ciena. Ciena projected sequential revenue growth of 5%-10%. This growth percentage translates to second quarter revenue between $173.3 million and $181.6 million. According to Thompson Financial, analysts were expecting $172 million in revenue next quarter. Additionally, CEO Gary Smith projected that full year revenues would rise 27% to 30% in 2007 compared to fiscal year 2006. Analysts had projected revenues to rise about 25% in 2007.

So why did shares of Ciena drop nearly 10%? Expectations, gross margins, and increased spending. Although Ciena’s numbers were strong, they missed analyst expectations by 1 cent per share. A one cent per share miss typically does not lead to an 10% sell off, but in this case we think many investors were expecting Ciena to handily beat analyst expectations. It is no secret that the big telcos and cable companies are spending in an attempt to offer improved bandwidth for voice, internet, and video applications. Investors in Ciena were hoping that Ciena would get a larger portion of this increased spending.

A slight decline in sequential gross margins from 45.5% to 44.6% also contributed to the slide. Considering demand in this sector, investors were probably hoping that margins would improve, not decline. Finally, Ciena projected an increase in spending in order to add manufacturing capacity so that they can keep up with demand. Apparently, investors are focusing on the short term negative of increased spending, but we have trouble understanding how spending due to increased demand could be viewed as a negative as some of the analyst notes have suggested.

Although the market has reacted negatively to Ciena’s earnings, we think that Ciena’s report provides further evidence that demand for increased bandwidth is still strong. Ciena is actually adding manufacturing capacity for the first time in many years. Large telecom and cable companies are continuing to upgrade their networks to handle surging internet bandwidth demands, and the margin issues at Ciena are company specific. Therefore, despite the 10% decline in share price at Ciena, we are still positive about the sector as a whole.

We sold shares of Electro Optical Engineering (Nasdaq: EXFO) and JDS Uniphase (Nasdaq: JDSU) a few days ago due to general market volatility. This move proved fortuitous as both of these stocks have dropped since our sell point. We are looking for another entry point for both of these stocks, but for the time being we are staying on the sidelines. Although we think that Ciena’s report shows that demand in the sector is still strong and growing, we are worried that the 10% drop in Ciena could carry over into shares of JDS Uniphase and Electro Optical Engineering in the short term.

We think that Ciena has sold-off farther than it should have based on this report. Underlying demand is still strong and guidance was better than expected. That being said, we still like Electro Optical Engineering and JDS Uniphase more than Ciena due to increased exposure to optical test and measurement equipment. When Ciena stabilizes, it will be time to buy Electro Optical Engineering and JDS Uniphase.