- Ciena saw strong data center growth offset by weaker service provider demand, with significantly better margins on business mix and cost/efficiency improvements.
- Covid-19 could tap the brakes on data center growth in the second half, but the long-term story remains strong with the 800G ramp just beginning.
- Ciena looks more fairly valued than undervalued to me now, but execution on share growth opportunities could still generate upside and management is building a good track record.
Not all suppliers to data center customers (particularly hyperscale customers) are benefitting equally, but I’d say on balance that it’s pretty clear that data center spending is still a strong driver for leading vendors like Broadcom (AVGO), Inphi (IPHI), and Ciena (NYSE:CIEN), with the latter’s share price up about 20% from the time of my last article. While Ciena’s performance relative to other optical equipment companies (including Cisco (CSCO), Infinera (INFN), and Nokia (NOK)) hasn’t been the strongest over the past three months, the one-year and two-year comparisons are more favorable, as Ciena has been riding a winning strategy for some time now.
I still believe that many of the key drivers for Ciena are firmly in place – potential share gains from rivals like Huawei and Nokia on the server provider side, ongoing growth in its webscale business, and relatively few meaningful competitors in that cloud/hyperscale market. Valuation is more challenging now; I don’t think Ciena is overpriced here, but I do see sell-siders stretching to validate ever-higher target prices, and I think upside is now tied more to outperforming a higher bar of expectations rather than convincing investors to reconsider Ciena’s positive qualities.
Better Margins Drive A Fiscal Q2 Beat
Ciena’s fiscal second quarter revenue was only a little better than expected, but gross and operating margins were significantly better than expected, beating sell-side estimates by almost four points and five-and-a-half points, respectively. Guidance for the remainder of the year was not necessarily that bullish on the top line, but higher margins are welcome and Ciena is establishing a pretty good reputation for conservative guidance (meaning there could still be some upside).
Revenue rose more than 3% YoY and 7% QoQ in the fiscal second quarter, with software and services outperforming products on a YoY basis (up 14% versus up 1%), while the reverse was true on a QoQ comparison (up 1% and up 9%, respectively). Converged packet optical products saw 5% YoY and 11% QoQ growth, with that growth driven principally by data center customers. Overall webscale revenue grew 28% YoY, beating expectations.
Gross margin improved three points from the year-ago level and almost two points from the prior quarter, with product gross margin up more than three points YoY and almost two points QoQ. Ciena benefited from ongoing process/cost improvement efforts, as well as a mix shift away from newer accounts (new business tends to come with meaningfully lower initial gross margins). While I do not endorse this view, I wouldn’t be surprised to see a few Ciena bears try to cast this in a negative light, suggesting that new business win activity is flagging. My own view is that the business is becoming more diversified (only one 10%+ customer) and Ciena is growing past a point where those new wins have the same negative impact on margins as before.
Ciena’s liquidity/cash situation is fine, and I see no issues with Ciena maintaining adequate liquidity and balance sheet flexibility through the Covid-19 pandemic and its aftermath.
The Second Half Could Be Slower, But The Opportunity Set Is Still Attractive
Probably the biggest near-term challenge for Ciena is the risk that Covid-19 issues disrupt some of its business activity in the second half of its fiscal year. The outbreak isn’t really hurting Ciena’s direct operations, nor the underlying demand drivers for data center customers, but it is at least plausible that Covid-19 could create some installation challenges/backlogs over the next few months (both Nokia and Infinera have mentioned this). On the flip side, Ciena, like Inphi, could also benefit from slower competitor validation/qualification activity. It’s plausible to me, then, that second half revenue growth could be a little slower, but not enough to meaningfully impact the long-term story.
As far as that long-term story goes, I still see Ciena positioned as a share gainer in optical equipment among service providers as they continue to spend on their networks. While Ciena has long enjoyed good share in the North American long-haul/metro optical market (over 30%), that hasn’t been the case in Europe or Asia. Recently, the tide has turned in Asia, with good wins in India and Japan, and I see the potential for Ciena to benefit from European service providers turning away from Huawei for security reasons and Nokia for product performance/development issues.
Data center, particularly hyperscale, also remains a significant growth driver, with Ciena barely seeing any impact from competitors offering 600G products (as I expected) and its own 800G products set to ramp in the second half of 2020. I certainly remain concerned about the “trees don’t go to the sky” risk with hyperscale spending (meaning that these growth rates can’t/won’t continue indefinitely), but there’s definitely money to be made in the near term.
I’m also modestly concerned about the risk that Inphi will disrupt part of Ciena’s market with its 400G-ZR interconnect products. About one-third of Ciena’s webscale business would be at risk in a worst-case scenario, which is clearly material, but Ciena has its own ZR effort and I don’t see the worst-case scenario materializing. Moreover, I think growth in the business overall can cover for some of the potential ZR-related losses.
My margin expectations for Ciena were higher than Street average estimates, so not a whole lot changes with my model at this point. I’m still looking for mid single-digit long-term revenue growth (annualized), with stronger growth in the near term. Share gains in optical equipment would likely be the biggest potential source of upside, though improved results in the software business certainly wouldn’t hurt.
In terms of margins, I was already expecting Ciena’s FCF margins to move toward the mid-teens over time, but I see that happening a little faster now. It’s certainly not unthinkable that there could be even more long-term upside (beyond the mid-teens) as Ciena’s mix and operational performance improves, but I’d remind readers that Ciena hasn’t delivered 10%+ margins over the last decade-plus, let alone done so on a consistent basis, so I think a little caution (or at least prudence) is still fair.
The Bottom Line
Between discounted cash flow and margin/return/growth-driven multiples of EBITDA and revenue, I think Ciena is basically fairly valued now. Cash flow suggests an annualized expected return in the high-single digits, which is okay but not great, while the multiple-based approaches support a mid-to-high $50s fair value. Of course, as seen in the case of Inphi, strong growth stories can garner very high multiples; I don’t think Ciena has the growth credentials to get that kind of valuation, but I don’t like to sell stocks/stories that are working just because of valuation.
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