Trevor Meunier
Bullishness on Ciena (NYSE:CIEN) has gotten me nowhere this year, as this large optical networking company has been hamstrung by its inability to secure the parts and components it needs to satisfy demand. While that demand has remained strong, and the company will head into 2023 with a strong backlog, the name seems to be a non-starter with the Street until the company can guide to meaningful sequential revenue growth and margin re-expansion.
Over the longer term, I still like Ciena’s leverage to service provider and webscale deployments, as well as opportunities to grow its routing and PON businesses, and I think the shares can deliver an annualized double-digit return. In the short term, though, it’s hard to see much upside beyond $50 unless and until the supply problems ease and management can guide to meaningful sequential revenue acceleration.
Supply Remains The Story
Ciena continues to struggle to secure the inventory it needs to satisfy otherwise strong demand for its converged packet and routing/switching equipment. Low-value chips remain the gating issue for the company, and supplier decommits cost the company about $60M in the last quarter and will likely cost another $200M or so in revenue in the fiscal fourth quarter due to the company’s inability to ship its high-margin products without those components.
Supply issues are not a Ciena-specific issue. Others in the space (broadly defined) like Arista (ANET), Cisco (CSCO), and Nokia (NOK) have had their revenue and margins compromised by supply issues. What I do wonder, though, is why Ciena seems to be suffering worse on a relative basis. Cisco talked about improving supply in its last quarter, and while Ciena’s analyst estimates have been heading lower, Arista’s and Cisco’s have been heading higher.
I know that some companies, Cisco included, have turned to broker markets and paid premiums to get needed components. While that pressures gross margin, I have to think it’s a better option than being unable to ship at all. Perhaps that’s just not an option for Ciena (it may be the case that the components simply aren’t available elsewhere at a palatable price), but it does stand as a lingering question, and supply issues could shadow Ciena into 2023 and lead to another round of estimate cuts.
When Supply Improves, Reacceleration Should Be Meaningful
Ciena exited the last quarter with about $4.4 billion in backlog, and while supply shortages did suppress the “bill” side of book-to-bill, the book-to-bill of 1.3x still supports the idea that demand remains healthy in the company’s core market.
Looking at 2023, I do see weaker spending trends in the data center market (Ciena’s Webscale business). Investors have started caring about balance sheets and cash flow again, and I expect enterprise companies to pull back on data center investments. Offsetting that to some extent should be stronger investments at the high end of the market (400G and above) and growth in interconnect. All told, I don’t think data center will be a particularly robust market for Ciena in 2023, and I do see some risk of pushouts even amidst better spending at the high end.
I’m less worried about the service provider side, and that’s where the company’s roughly 60% leverage to this end-market will help. Service providers still need and want the systems they’ve ordered from Ciena and I haven’t seen any evidence of meaningful cancellations. I definitely expect orders to slow, but Ciena will be delivering out of its backlog (once supply improves) and that should bridge the company over to a reacceleration of orders beyond 2023/2024.
Outside of these core markets, Ciena still has meaningful growth opportunities tied to replacing Huawei with customers in Asia and Europe; that process has been slowed by the supply issues, but the replacement opportunities are still real.
Routing, too, is an attractive opportunity for Ciena. In a rather short time Ciena has already grabbed around 2%-3% share of the service provider and edge routing markets (according to Omdia), and I believe the company can take more share in the coming years. There’s a long way to go for Ciena to seriously threaten Cisco (around 30% to 35% share, depending upon the market), Nokia (20% to 30% share), and Juniper (JNPR) (around 16% to 18% share), but Ciena isn’t so much looking to supplant Cisco as it is to take advantage of select parts of the market with attractive margins. Likewise with PON, where the company has opportunities to gain share with existing customers like AT&T (T).
The Outlook
I’m expecting around $860M or so in revenue for the upcoming fourth quarter, a little better than the current sell-side average, and a gross margin around 40% (Ciena’s trough margin is coming in about two points lower than I’d expected). I believe there could be some upside to the roughly 3% sell-side average estimate for operating margin (around 4%), and thus some upside to EPS as well.
I’m honestly not that interested in the fourth quarter results compared to management’s guidance. For the stock to work, the Street needs to hear that supply constraints are improving and that revenue will start reaccelerating – maybe not in the next fiscal quarter (the Street’s expecting about 3% qoq growth), but soon. I’m concerned that there hasn’t been as much progress/improvement on supply as hoped, though, and that FQ1’23 and FY’23 numbers could head lower. On an ironically positive note, reports of increasing order cancellations and pushouts from chip companies could signal that availability is improving for Ciena, but we’ll have to wait to hear from management.
My FY’22 and FY’23 revenue estimates are certainly lower now versus my prior article (about 9% and 7%, respectively, but I do expect double-digit growth next year and in FY’24 as well, and I still believe Ciena will achieve long-term revenue growth around 6% to 7%. Margins (EBITDA, operating, and free cash flow) will be poor this year and better next year, but it’ll take a sustained recovery into FY’24 to get back to high-teens EBITDA margins and low double-digit FCF margins. Over time I’m still looking for mid-teens FCF margins to support high single-digit FCF growth.
The Bottom Line
As I said in the open, I believe Ciena is priced for a long-term annualized return in the double-digits; data traffic continues to grow and Ciena’s products facilitate that traffic. In the short term, though, the stock won’t work without visibility into revenue reacceleration and I think the shares could be capped around $50 until that happens. I think these shares are still worth owning, but I can certainly understand waiting for evidence of that reacceleration to buy into the name.
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