A handful of “surely the good times can’t last” downgrades pressured Ciena’s (CIEN) share price in late September, but the stock has since come back on renewed confidence that those good times actually can last a bit longer, as Ciena continues to gain share in optical systems and gain traction with its new offerings. Moreover, if the software business really is on a better growth trajectory, it will answer some of the concerns about that business and offer another driver of growth over the next couple of years.
The set-up going into 2019 isn’t perfect. Obviously the markets are jittery. On a more company-specific basis, there’s still some risk of disruption from new product introductions from Acacia (ACIA) and Infinera (INFN), as well as risks from service provider budget priorities and a possible slowdown in datacenter growth. Those risks don’t really faze me on a mid-term basis, but could create some choppiness on a month-to-month or quarter-to-quarter basis. Ciena sits toward the low end of my upwardly-revised fair value range, and I’d consider prices in the low $30’s (or below) to be solid buying opportunities for a company with good ongoing leverage to both service provider and datacenter spending.
A Nice Beat-And-Raise
More than a few sell-side analysts seemed concerned that Ciena’s strong year-to-date performance and rising expectations constituted a growing risk going into fiscal fourth quarter earnings and FY 2019 guidance, but Ciena came through once again.
Revenue grew 21% in the fourth quarter, with balanced growth rates in both products and services, and surpassed expectations by around 4%. Networking revenue was up 19% on strong growth in converged packet, while service revenue rose 15% and software revenue rose 61%. Although Ciena doesn’t (yet) break out webscale revenue separately, it was once again 20% of the total mix, as the company continues to do well with hyperscale customers.
Margins have been a point of consternation with Ciena analysts and investors in the past, but the company is executing well here as well. Gross margin improved half a point from last year, with product margin up about a half-point, and beat expectations by more than two points. As a quick reminder, gross margins can be pressured in the short term when the company makes sizable chassis sales, but subsequent line card orders tend to drive rebounds (as does an improving mix). Operating income jumped 41%, with operating margin up two points from the year-ago period.
On the guidance front, management’s new midpoint for fiscal Q1 revenue was more than 4% above the prior average sell-side estimate, with gross margin slightly below (though management may be playing it cautious). Although the company didn’t give full-year guidance, management’s comments suggest a bullish outlook – management sees strong momentum in North America and India, believes it gained share in FY’18 and will do so again in FY’19.
Risks, Yes … But Opportunity Too
Ciena has gained meaningful share in the datacenter/hyperscale market and has certainly outperformed would-be rivals like Nokia (NOK) in developing that opportunity. That strong performance may be a modest vulnerability in 2019. Most third-party research suggests that datacenter spending will slow in 2019, as companies digest past expansion investments and as the denominator continues to grow.
On top of potentially slowing overall spending, Acacia’s new AC1200 modules are a potential threat to Ciena’s business, as might be Infinera’s new Cloud Xpress. I had thought that Ciena might take the opportunity during fiscal fourth quarter earnings to introduce a new 800G product, but I was wrong. An announcement could still take place in early 2019, and I still believe that a new 800G product from Ciena is likely. I don’t think either Acacia or Infinera are likely to swipe huge share from Ciena, but a slower timeline to an 800G product could drive more share than I expect and slower datacenter growth in FY19 could magnify even modest share losses.
Service provider spending decisions are another potential disruption in Ciena’s FY’19 business. Providers are going to start spending on 5G capex, and while Ciena is leveraged to 5G through metro and datacenter interconnect and an overall increase in fiber-based bandwidth demand driven by the new apps that 5G can/will enable, the timing of that spending is certainly not assured and customers like Verizon (VZ) and AT&T (T) could reprioritize equipment spending away from Ciena. Again, I don’t see much risk that Ciena doesn’t get the orders eventually, but there is timing risk and Wall Street isn’t famous for patience.
I also count Ciena’s software efforts in the “risk and opportunities” bucket. Management sounds more confident about their ability to drive increasing software penetration, and user feedback on Blue Planet has been pretty positive, but the company’s progress with the software business has been lumpy at best, and doubling Blue Planet’s revenue from FY’19 to FY’21 could prove to be an aggressive target.
I have increased my estimates (particularly over the next two to three years) for Ciena’s revenue, and I still believe a long-term growth rate in the area of 5% is fair. As time goes on, I expect software and datacenter will have to do more of the heavy lifting for that growth, but the 5G spending cycle will almost certainly last for several years. I’ve also raised my long-term FCF margin assumptions, and this is where I’m a little more concerned that I’m getting too aggressive too soon, as the company has to do better with its software business to deliver higher and more consistent FCF margins in the future. I think they can and will, but it’s a risk.
The various modeling changes, as well as moving the models forward a year, pushes my fair value range up from the high $20’s-low/mid-$30’s to the low/mid-$30’s to high $30’s. I use both a discounted cash flow model and a margin-driven EV/EBITDA valuation approach, with the later driving the high end of the range in both cases. I’d also note that the EV/EBITDA approach is more sensitive to market sentiment.
The Bottom Line
Ciena will still have some competitive and end-market challenges in FY’19, but I believe management has done a lot to build confidence in the basic model. The company has gained share with strong new product offerings and I believe the company has compelling offerings compared to Nokia, Infinera, Acacia, and others. If management can get the software business on a stronger, more consistent trajectory, I think there’s still room for upgrades and re-rating. It’s easier to like the shares lower in the $30’s, and I could see the shares fading after earnings, but this is a stock I’d definitely revisit on weakness.
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.