After A Solid Rebound, Ciena Isn't Quite As Appealing

| About: Ciena Corporation (CIEN)
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Summary

Ciena reported in-line revenue and better margins, but guidance was soft.

100G deployments are still far from the norm in long-haul and metro networks.

Ciena's partnership with Ericsson could raise the company's profile in Europe and make it a more effective rival to Alcatel-Lucent and Huawei.

Back in mid-December, I thought Ciena (NASDAQ:CIEN) looked like a good buy-the-dip opportunity. Even with the post-earnings pullback on Thursday, the shares are still up about 15% since that piece, nearly tripling the return the S&P 500. I am bullish about the company's partnership with Ericsson (NASDAQ:ERIC) and its prospects for growing its global 100G share. At the same time, though, that is going to be a long-term process and I don't see as much undervaluation in the shares as I did three months ago.

Meeting The Targets For Fiscal Q1

Ciena reported 18% yoy revenue growth and met sell-side expectations, but results were down 9% sequentially. Converged Packet Optical revenue rose 39%, Packet Networking was up 13%, and Software ticked up 1%, while Optical Transport declined 30%.

The company also outperformed on margins. Gross margin slipped 170bp from last year and rose 200bp sequentially, beating the average sell-side estimate by 170bp. Operating income was likewise stronger than expected (up 24% yoy and 15% qoq), with operating margin coming in 270bp above estimates.

Guidance Prompts A Skid

What analysts and investors want to hear from Ciena is that 100G demand is growing at an accelerating clip, fueling the company for beat-and-raise quarters. That's not happening, as Verizon (NYSE:VZ) and AT&T (NYSE:T) (among other service providers) are taking a more cautious approach with their capital spending.

Revenue guidance was about 1% light, while the gross margin target for Q2 ("low 40's") was consistent with expectations. Operating expense guidance was a little higher than expected, boiling down to a probable operating margin about a point to point and a half below expectations. That's not terrible guidance, but it's not the "strong and getting stronger" that the Street wants to hear.

100G Only Getting Started

Ciena has North American optical market share estimated in the mid-20%'s to low 30%'s, and it has a particularly strong 100G platform. Long-haul deployments of 100G did accelerate throughout 2013 (ending the year around one-quarter of deployments), but 100G is still only 5% of metro and long-haul combined. Further expansion of 100G as a share of metro/long-haul seems quite likely to me, and Ciena should be able to ride that momentum as customers like AT&T have only just started 100G deployments. Verizon, too, has a lot of 100G left to add, and Ciena is likely to be a beneficiary.

Will Ericsson Move The Needle?

Earlier this year Ciena and Ericsson announced a strategic partnership that could ultimately provide a significant boost to Ciena's business. Ericsson's sales force will help push Ciena's OTN switching products to its customer base, while also integrating Ciena's WaveLogic technology into its IP edge routers. The two companies will also collaborate on SDN and NFV products.

My first reaction to this announcement is some skepticism. Ericsson hasn't always been the most dynamic partner a company could want, as Juniper and Calix have seen. On the other hand, Ericsson has a strong client list and market share outside of North America. Given Ciena's strength in the U.S. and weakness in international markets (single-digit share in some cases), Ericsson's assistance could lead to share gains against the likes of Alcatel-Lucent (ALU) and Huawei. Assuming that the company's can work together well, the potential for offering a more complete suite of products could be mutually beneficial, particularly as it concerns competing with end to end solutions from Alcatel-Lucent and Huawei.

I think it's particularly worth noting that Ericsson is strong in Europe and European politicians are getting increasingly concerned (and vocal) about Huawei's presence in the market, so this partnership could get a tailwind from that issue. I also wonder if, down the road, this could facilitate a re-entry into the Chinese market for Ciena.

Leveraging A Leadership Position

Ciena's leadership in 100G is not insurmountable and there are only so many deployments the company can win (though growing metro adoption will help). Ciena badly needs to gain share from Alcatel-Lucent and Huawei in Europe to extent the value of its technology platform, and that's where the Ericsson deal comes in to the story.

The Ericsson deal is not likely to really change much this year, and I'm staying with my basic 6% to 7% long-term revenue growth outlook for now. I am still looking for Ciena to realize meaningful profit and FCF leverage as optical deployments continue, and that cash generation should allow the company to de-lever and/or consider selective acquisitions (or capital returns to shareholders).

The Bottom Line

If the Ericsson deal works out, I could see the fair value on these shares moving up to around $28, but Ericsson's dicey partnership history leads me to be cautious about factoring that all in today. Without the Ericsson deal I believe Ciena's fair value is around $25, which doesn't suggest huge untapped potential. As I do have a higher-than-normal discount rate on Ciena, though, I do believe that shares are priced for a low double-digit annual return from here.

Disclosure: I 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.