Ciena: Outlook Remains Constructive, Despite Lowered Top-Line Growth For 2020

Summary

• Growing network traffic and demand for bandwidth remain a strong tailwind for Ciena's applications, as its WaveLogic optical technology has been largely adopted by service providers, web-scale providers, and MSO.
• The outlook for the remainder of the year 2020 is more modest in the international market, as the limited access to the sites has affected the speed of new projects.
• Target price of $62 is appropriate if not conservative since my assumptions are based on a doable top-line growth and margins in line with the company expectations.

Quarterly results posted by Ciena (NYSE:CIEN) reflected business and operation strength, as the network solutions provider delivered revenue and earnings growth exceeding estimations. Meanwhile, Ciena has lowered the top-line growth forecast for the year, in light of the coronavirus-related environment.

Despite a near-term relatively neutral backdrop, the innovation path of the company and recent project wins underscore the fact that Ciena is well positioned to benefit from the high demand for bandwidth in the years ahead.

Earnings highlights

Throughout the recent quarter finished at the end of April, Ciena faced some supply disruptions related to components constraints, extended lead time, and temporary reduction in activity due to coronavirus-related restrictions. Despite that, Ciena notched revenue growth of 3.4% year-over-year, hitting $894 million, driven by web-scale projects that now represent 24% of total revenue and Tier 1 service providers, notably in North America and EMEA.

Gross profit margin climbed to 46.9% from 43.9% a year ago, as Ciena has moved forward on its operation optimization strategy, including cost reductions and vertical integrations, targeting a margin gain of 100 basis points to the range of 43% to 45%. In addition, Ciena has also been temporarily benefitted from lower costs in the early stage of the projects, given difficulties in engaging with customers caused by the pandemic.

Operating expenses were also lower than expected, driven by a reduction in travel expenses after the pandemic. This scenario of top-line growth, combined with operational efficiencies and limited expenses, resulted in a jump of adjusted operating margin to 17.9% from 12.7% a year ago and adjusted EPS climbing to $0.76 from $0.48% last year, handily outpacing consensus of $0.52.

As we can see below, quarterly results have just added to the operational improvement trend experienced by Ciena over the last 5 years, especially after mid-2018 when we saw gross profit margins increasing toward the target range of 43% to 45%.

Source: YCharts

Outlook is positive

Growing network traffic and demand for bandwidth remain a strong tailwind for Ciena's applications, as its WaveLogic optical technology has been largely adopted by service providers, web-scale providers, and MSOs. As an example, the recently released WaveLogic 5 Extreme, with a capacity of 800 G, was already shipped to a dozen customers. Meanwhile, Tier-1 providers, such as Telia (OTCPK:TLSNF), Verizon (VZ), and Deutsche Telekom (OTCQX:DTEGF), will expand their networks using this solution in order to address growing traffic from multiple applications, like video streaming, cloud computing, and growing demand for bandwidth in the mobile field as the rollout of 5G ramps up.

These recent project wins are strategic developments for Ciena as the first deployment will pave the way for future expansions going forward and build on consistent market share gains achieved over the past years, as illustrated in the chart below.

Source: Ciena Investor Presentation Spring 2020

The outlook for the remainder of the year 2020 is more modest tough, especially in the international market, as the limited access to the sites has affected the speed of new project engineering activities, lab certification, and delivery services.

Therefore, while the broader market, ex-China, is expected to remain flat in 2020, the management team has lowered top-line growth for the fiscal year to 2% to 4% from the original 6% to 8%, as Ciena can continue to outgrow the market.

Although near-term prospects may disappoint somehow, Ciena remains well positioned as a leading network provider to capture a relevant portion of new demands in the years ahead. Adding to this positive scenario, the competitive landscape has been more favorable to Ciena, as increasing hostilities between U.S. and China has created additional obstacles to its main rival Huawei, the worldwide market leader, in the international market outside China, notably Europe, which, in turn, should open further opportunities to Ciena going forward.

Valuation is not a steal, but the upside is reasonable

With P/E Forward of 20.0x and EV/EBITDA forward of 12.3x, shares of Ciena are currently trading at a small premium of 6% and 8%, respectively, relative to most established and profitable communications equipment players (Nokia (NOK), Cisco (CSCO), Juniper (JNPR), Arista (ANET), F5 (FFIV), and Motorola (MSI)). That is, in my view, largely justified, given Ciena's track record of outpacing market growth and its margins growth forecast.

Assuming that Ciena can deliver revenue growth of 3% for 2020 (in the mid-range of the outlook) and 6% over the coming years, I estimate the fair value of Ciena at $62, using the 5-year DCF model, implying nearly 14% upside over the current price level.

I regard this target price as appropriate if not conservative since my assumptions are based on a relatively doable top-line growth mentioned above. In addition, I considered margins roughly in line with company expectations (operation margin of 16% in 2020 and 17% over the coming years) and terminal EV/EBITDA multiple converging to the average of the communication equipment peer group of 13.2x.

A further upside to shares of Ciena lies in the usual premium valuation warranted to outperforming companies. This status will be reassured to Ciena as long as it continues to capture growth opportunities, taking advantage of high demand for bandwidth, and, consistently, leverage its operation over time. That said, Ciena is a buy, despite some weakness we might see in the price action over the course of the year due to the constrained business environment.

Analyst’s Disclosure: I am/we are long CIEN. 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.