Ciena Sliding A Bit As The Sell-Side Rebuilds The Wall Of Worry

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About: Ciena Corporation (CIEN), Includes: ACIA, INFN
by: Stephen Simpson, CFA

Summary

Ciena shares have been fading since a big run after strong fiscal third quarter earnings, and three sell-side analysts have downgraded the shares on an assortment of growth-related concerns.

Acacia's upcoming new product release is a threat, but Ciena should be able to respond fairly quickly with an even more powerful product.

Slower data center spending is a bigger risk, as even Ciena management isn't too optimistic about further significant share gains in that market.

Ciena shares are sliding towards a potentially attractive buy-in price, but investors should carefully consider the risk of a data center spending slowdown in CY19 and a wider re-rating for tech stocks.

Ciena (CIEN) has been on a roll. Revenue rose 12% in the fiscal third quarter (beating expectations by 3%), gross margin was stronger than expected, and the company has been on a multiyear market-share-building run in both its core WDM market and in webscale. All of that has fueled a market-beating 33% run in the stock over the past year, so of course now some eager beavers on the sell-side are trying to beat the rush and downgrade early.

Wait, what?

It’s not all that uncommon to see calls that otherwise might look bold come out around this time, as there’s not much else to talk about in the weeks before third quarter earnings, and there are some near-term drivers that could weigh on Ciena’s growth. How management sets expectations coming out of this next quarter will clearly be important, as the run in the shares has somewhat emptied the tank for positive drivers.

… And Here Come Some Downgrades

Over the last month or so, there have been three sell-side downgrades of Ciena. While each analyst has their own explanation for the move the common themes are worries about Ciena’s growth rate in 2019 in the face of more vigorous competition and less vigorous core spending. These downgrades also noted, and I can’t say that I entirely disagree here, that Ciena shares have been on quite a run and it’s increasingly hard to find the near-term drivers that can push the shares meaningfully further in the short-term.

A New Competitive Offering On The Way

Perhaps the biggest near-term threat to Ciena is the upcoming launch of Acacia’s (ACIA) new AC1200 coherent module. Including Acacia’s Pico DSP, and continuing a strong track record in low-power capabilities, the AC1200 will leapfrog the capabilities of Ciena’s current market-leading WaveLogic technology by offering two wavelengths of 600Gbps capacity in a module roughly the size of an iPhone. Not only is that more than the 400Gbps that Ciena can offer, it breaks down as a better price-per-bit as well. ADVA Optical Networking (OTCPK:ADVOF) has already announced plans to put three of these in its Teraflex platform, and commercialization could begin in the first or second quarter of next year.

A strong new competitive platform is certainly a threat to Ciena, particularly as the company has been benefiting, and growing its data center market share, on the back of its technological superiority. With the lower per-bit cost, there’s a risk that Ciena could have to offer some pricing concessions to maintain share, which would hurt margins (and margins are always a controversial point with Ciena). There’s also some incremental risk from the introduction of a new Infinera (INFN) product around mid-year.

But …

Ciena has their own potential product ramp. Management already confirmed a 800G product earlier this year, and that 800Gbps WaveLogic successor could be on the market in the second half of 2019. I would expect management to announce something relatively soon with respect to this product, but Ciena hasn’t always been so consistent with the timing between announcing the DSP and launching the relevant commercial product (though fourth quarter earnings and FY 2019 guidance would make some sense…).

A Slowing Market?

Although Ciena has gained share in its core WDM market, the underlying growth rates for metro and long-haul optical deployments aren’t so exciting. Where I expect growth in these core markets to be in the low-to-mid single-digits, growth in the data center has been in the double-digits for Ciena and needs to stay there for the company to meet expectations in 2019.

Given the heavy investments that many data center operators have already made, and some possibly wobblier outlook for demand growth in 2019, that spending could decelerate some in 2019. I believe some of this anticipated deceleration is already showing up in sentiment/expectations for chip stocks, both on the memory and logic side, and this could be a meaningful headwind for expectations.

It’s hard to say exactly what that will mean for Ciena, though. There are a lot of components to overall cloud spending and where you sit in the ecosystem matters. Switching demand, for instance, has exceeded overall spending growth as hyperscalers like Amazon (AMZN) and Microsoft (MSFT) use leaf/spine layers in addition to core layers. Likewise, hypescalers are still building out optical interconnects between their data centers, which could fuel healthy ongoing growth. Still, even Ciena management has acknowledged that it’ll likely be difficult to grow their share much further in cloud (which UBS estimates at around 40%) in the near term, so market growth is a very important driver.

Also relevant to market growth, some of the negative sentiment around Ciena has targeted risks to the company’s strong business in India. I’m more skeptical about this. Infinera and Coriant could be a more competitive combo-threat in emerging markets like India (where Coriant is more aggressive on price), but I think it’ll take a while before those two operations are singing in harmony and Ciena can benefit in the meanwhile from Bharti Airtel (OTCPK:BHRQY) looking to answer Jio’s large capacity deployment, as well as potential share gains with Bharti.

A Need For Self-Improvement

While Ciena has done well in some areas, and has competed effectively with companies like Infinera and Nokia (NOK) in the data center market, they haven’t done everything well. Management has expressed at least some disappointment in both its coherent processing chip business and its Blue Planet software business. If management can lay out a convincing plan for improving both in the coming years, I believe that would go over well with investors.

The Bottom Line

I’m not making any large changes to my model relative to my last update, but there are a few tweaks that move the fair values a bit. The shares continue to trade between my DCF-based fair value (now above $28) and my EV/EBTDA-based fair value (still in the low-to-mid $30’s), though they’re sliding closer to my DCF fair value, which is where (or below) I prefer to buy. I won’t completely dismiss the risks Ciena is facing over the next 12 months, and I don’t think any investor should ignore the larger risk that a very healthy run in tech stocks could be petering out, but in terms of Ciena-specific factors, I think this is a still a strong story and could be worth a closer look as the share price slide opens up another opportunity.

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.