Ciena (NASDAQ:CIEN) reported a strong third quarter that sent shares up 8%. Sales missed by $1.57 million but increased 11.2% y/y, which was good for a 4.7% increase on top of Q2's strong top line performance. But the better than expected bottom line performance was what really got investors excited, as non-GAAP EPS of $0.42 beat estimates by $0.04. After Q2 I wrote an article explaining why I believed shares were fairly valued at the time, but the stock price of CIEN has advanced in recent months (up 20% in August alone). However the increase in price was more the result of a broad-market upturn rather than anything specific to the company, in our view. No material news has come out that changes our view on Ciena, and we don't expect shares to appreciate much from current levels over the next twelve months.
There are certainly some positives to take away from CIEN's most recent quarter. Despite the top-line miss, Q3 was evidence that the company's efforts to broaden its portfolio, diversify its business lines, and expand into new geographic segments are paying off. CIEN's core networking platform segment grew 80% y/y as the company added 5 new customers to its converged packet optical business (which increased 68%). Revenues from North America and EMEA remained constant on a percentage of total sales basis, but strength in the Asia Pacific (which increased almost 50% y/y) offset weakness in Latin America, which declined nearly 400 bps on a percentage of sales basis. Most importantly, sales to non-telecoms companies expanded to a record 37% of total sales, reflecting strong demand from web-scale providers (for which sales accounted for 12% of total revenues). Given the challenging competitive dynamics of the telecom optical equipment space, we view this positively.
Non-GAAP adjusted gross margin expanded 150 bps to 46.8%, thanks to an improved product mix. But we think the potential for further margin expansion is limited. This is because price competition is intense and increasing in the optical equipment space. Ciena and its competitors have limited pricing power because they sell products that are relatively similar to a concentrated buyer industry where the likes of AT&T (NYSE:T) and Verizon (NYSE:VZ) have leverage to negotiate favorable prices. In addition, competition from smaller players and Chinese rivals (such as Huawei and ZTE), who are attempting to undercut on price, has increased. Ciena is less established than its major competitors Alcatel-Lucent (ALU) and Cisco (NASDAQ:CSCO), and we believe this is responsible for the firm's strategy of spending aggressively in order to get new products to market and grow share. CIEN did cut costs in Q3, which drove the adjusted opex rate down slightly, but the firm's heavy investments continue to weigh on profitability. CIEN reported GAAP operating losses for 5 consecutive years up to 2013, and has averaged an operating margin of just 3% since.
Management likes to talk about its non-GAAP results, which adjusts reported income for restructuring, acquisition, and other operating expenses that are supposed to be non-recurring. However these expenses have recurred for years, and are a byproduct of the firm's aggressive strategy that we think the firm will continue to pursue in an attempt to grow share and diversify its revenue streams. Over the last five years, these expenses have accounted for 3-5% of revenues, on average, and investors should not dismiss them.
Q3 was really the same old story with Ciena. The company increased market share and showed strong growth, but is having trouble expanding margins after considering all the costs that go into achieving that growth. Pricing will continue to be an issue, and the firm must rely on cost cuts to expand margins. CIEN did trim some fat in Q3, which was an encouraging sign, but we don't think margins will expand much further anytime soon. Shares are fairly valued at this time, and investors should wait for a better entry point.
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.