Henrik5000
Supply chain issues hamstrung Ciena (NYSE:CIEN) throughout its fiscal 2022 year, as the company couldn’t get the chips and other components it needed to fulfill robust orders from telco, enterprise, and cable companies. The fiscal fourth quarter was a different story, though, as the company was finally able to fulfill more of its component needs, allowing for a double-digit sequential growth rate in its core networking equipment business.
Ciena shares spiked about 20% on the strong fourth quarter beat and management’s guidance for FY’23, but the company isn’t completely out of the woods yet where margin recovery is concerned. Even so, I believe the shares remain undervalued with more visibility on mid-to-high single-digit revenue growth (stronger over the next few years) and a sustained margin recovery, not to mention share growth in its core markets and expansion into meaningful new adjacent markets.
Trouncing Estimates On A Supply Recovery
Reporting before Ciena, other companies in the peer group (broadly defined) like Arista (ANET), Cisco (CSCO), Coherent (COHR), Infinera (INFN), and Lumentum (LITE) reported varying degrees of improvement in component availability. Ciena benefited from this as well, with management noting a meaningful improvement in chip supplies in the second half of the quarter (both directly from suppliers and through the broker market). This, in turn, allowed the company to finally deliver more meaningful revenue from its backlog, including higher-margin modem products.
Revenue declined 7% year over year, but rebounded about 12% sequentially to $971M, beating by 14%. While I had expected the company to come in above sell-side expectations, Ciena handily surpassed that projection. Network product revenue declined 9% yoy and grew 13% sequentially, beating expectations, with optical (down 14% yoy, up 15% qoq) beating by about 20%. Switching/routing was also strong, with organic growth around 15% that marks ongoing share gains. Software revenue rose 8%, while service revenue declined about 1%.
Gross margin declined 110bp yoy and improved more than five points sequentially, beating expectations by five points, as product gross margin improved almost seven points from the fiscal third quarter. Margins were boosted by lower freight costs and a richer product mix (modem vs. line systems), with some offset from higher broker costs.
Non-GAAP operating income fell 28% yoy and rebounded 70% sequentially, smashing sell-side expectations, with a nearly 10-point operating margin beat.
Ciena did miss sell-side expectations for free cash flow (as well as my own) by more than $150M, with the company continuing to sock away components to ensure its ability to stay on track with assembly and delivery. Raw material inventory soared from $175M in October of 2021 to $665M, but I consider this a good use of capital given ongoing uncertainties in the supply chain (even though I do expect further improvement from here).
Guidance Wasn’t A Complete Win, But Trends Are Still Favorable
With a strong backlog ($4.2 billion, down 5% qoq but still around 115% of trailing 12-month revenue) and improving component availability, management raised guidance for FY’23. Management is looking for $4.25B in revenue against a prior sell-side estimate of $4.08B, with the first quarter expected to come in around $950M (versus an $873M sell-side average). Management also guided to 11% growth through FY’25, with 5% underlying optical market growth.
I’m not going to ignore improved guidance, but I do think context is important. Earlier in 2022, the Street was expecting around $4.3B-$4.4B in FY’23 revenue, so Ciena hasn’t yet fully regained what it has lost from component shortages. Likewise, the implied FY’25 target of $4.96B is close to what I’d been expecting before the component availability issues hit the company, so while Ciena is getting back on track, there are still lingering impacts from supply issues.
Likewise on margins. The mix shift that benefited the fourth quarter (more higher-margin modems) is likely to reverse at least partially next quarter and broker expenses are still relevant. With that, while Ciena guided to better-than-expected revenue for FY’23, the gross margin guide (42% to 44%) was still a little soft against a sell-side estimate of 43.4%.
Looking at industry trends, I do expect to see weaker overall 5G spending in calendar 2023, but Ciena should continue to benefit from healthy demand in the telco sector – traffic continues to grow and major telcos like AT&T (T) and Verizon (VZ) couldn’t get the equipment they wanted (and ordered) in 2022 due to the component issues hitting the industry. Ciena, then, should see healthy revenue on the basis of a still-strong backlog.
I’m not as bullish on the enterprise side, as more and more companies have disclosed weakening demand and orders from data center customers (including Lumentum). Orders have held up better at Ciena, though, and demand for high-end systems could lead to some relative outperformance. Orders were also strong in the cable end-market.
Share Opportunities, As Well As New Market Opportunities
While Ciena is still a very small fish in the edge routing pond, with around 3% share in edge routing versus 28% for Cisco and Nokia (NOK), the company has been making strong progress in recent quarters, and the company continues to leverage the Vyatta deal.
Management has also looked to increase its leverage to passive optical networking (or PON) and edge networking through more M&A. Back in late November, the company announced the acquisition of Tibit (broadband access via PON) and Benu Networks (software), and I like the company’s ongoing efforts to target opportunities like residential broadband and fixed wireless access.
In addition to share gain opportunities in edge routing/switching, the Huawei opportunity remains real. Those component issues in 2022 have hampered the company’s ability to gain share by displacing Huawei installations, but more of those orders should become deliverable over the next 12-24 months, and this remains an ongoing driver for the company and an opportunity to gain share in the European optical equipment market.
The Outlook
My FY’23 revenue estimate is now about 5% higher than it was, while the changes to my FY’24 and FY’25 estimates are considerably smaller (as I’d been modeling a recovery based on improved ability to deliver on the backlog). I also remain bullish on longer-term opportunities like edge networking, and I think 6% to 7% long-term revenue growth remains a valid target (closer to 7% now), with low double-digit growth over the next three years.
As far as margins go, I expect adjusted operating margin to recover to the mid-teens in FY’24 and the high teens in FY’25 and I think adjusted EBITDA margin could close in on 20% in FY’25. My FCF margin expectations haven’t changed much, as I still expect long-term improvement toward the mid-teens (driving long-term adjusted growth close to 8%), but the next couple of years could be choppy as the company works down working capital once management is more confident on the supply situation.
Putting a difficult FY’22 behind the company significantly improves the fair value I get from a discounted cash flow approach, and I still believe that Ciena is priced for a low double-digit annualized return. Short-term margin/return-based valuation is more tricky. The shares don’t look undervalued on FY’23 numbers, but I also don’t think FY’23 is going to be a representative year for the company’s true earnings power (despite the revenue upgrade, EBITDA expectations aren’t much higher); if I move ahead to FY’24 and discount back a year at a 10% discount rate, though, I do get a fair value in the low $60’s using a 12.75x multiple on my FY’24 EBITDA estimate.
The Bottom Line
Clearly Ciena shares have already seen a strong relief rally, and I think the worst of the component availability issues are behind the company. I do see opportunities for the company to outperform on revenue and margins in FY’23-FY’24, but I also have some concerns about how the macro outlook may impact sentiment – I don’t expect order trends in the telco and enterprise markets to be all that strong, and the Street may take a more skeptical or cautious view on Ciena’s ability to outgrow those trends. Even with that risk, I still think these shares are worth owning today.
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