Ciena: Supply Chain Challenges, But No Change To Multiyear Story (NYSE:CIEN)

Supply chain challenges added another pelt to the wall when Ciena (NYSE:CIEN) warned in mid-February that the company would miss fiscal first quarter targets due to supply chain challenges, and management subsequently indicated that supply chain pressures remained a risk in the second quarter. While this is a setback, the company still grew more than 10% in the quarter, is still poised to benefit from significant spending growth in telecom and datacom markets, and is still an attractive play on global data traffic.

These shares have given back about 7% since my last update, underperforming rivals like Cisco (CSCO) and Infinera (INFN) by around 7% to 10%, with Nokia (NOK) performing similarly. While the near-term supply challenges take a trivially small amount of my fair value estimates, the share price decline has these shares set up again for a double-digit long-term total annualized return, making this an attractive name to consider again at this price.

Shackled By Its Supply Chain

Demand is not an issue for Ciena today, but supplying that demand has proven more challenging than management expected. Two supply chain issues late in the fiscal first quarter, one an unexpected shutdown at an EMS partner, the other an unexpected shortfall in low-ASP electronic components (often called “jelly bean components”). While jelly bean components are typically effectively generic, there’s an overall lack of excess capacity/supply these days, and my sense was that the shortfall occurred too late for alternate sourcing to offset the problem.

Revenue rose a little less than 12% year over year in the quarter (and declined 19% sequentially), missing the sell-side target predating the mid-February warning by about 3%. Network product revenue rose 9%, with strong growth in the re-energized routing/switching business (up 33% yoy and 16% qoq) and weaker results in the optical business (up 6% yoy, down 28% qoq). Software revenue rose 41%, with Blue Planet up 25%, while service revenue was up 9%.

Gross margin actually benefitted from the revenue shortfall, as initial hardware sales can be lower-margin sales (lower-margin chassis) and software was a larger part of the mix. Overall gross margin declined about two points year over year and 10bp qoq to 46.2%, still beating expectations by close to a point. Product gross margin declined 340bp yoy and 80bp qoq to 44.6%, while software and service gross margin improved almost four points to 52%.

Operating income declined 10% yoy and 43% qoq, though operating margin still beat Street expectations by 30bp (down 280bp yoy and 500bp qoq to 11.8%).

Not surprisingly, there was a significant uptick in inventory (up 22% qoq), with the company socking away more components (“raw materials” up 69% qoq) to better ensure that it can deliver on its backlog in the coming quarters.

Growth Coming Along More Or Less As I Expected

Ciena’s fiscal first quarter only included one month of 2022 (January), but between the trends in the business here and commentary from other telecom/datacom providers in recent months, it does sound like 2022 is more or less on the trajectory I expected with respect to industry spending.

I thought U.S. telcos would keep spending at a high level, but not necessarily see a dramatic increase, while European and Indian customers upped their spending. Ciena saw 8% growth in telco spending in the quarter, though it almost certainly would have been higher if the company hadn’t run into those supply chain challenges. As the year rolls on, I expect strong ongoing spending from companies like AT&T (T) and Verizon (VZ).

I thought 2022 would be a good year for cable spending, and Ciena reported that revenue from cable MSO customers rose 68% in the quarter. I was also looking for double-digit growth in data center/webscale spending, and webscale was up 10% in the quarter, though still well below the recent peak in FQ3’21 ($169M versus $247M).

Lumentum (LITE) recently projected 20% or better growth in U.S. telecom and datacom spending, along with 30% traffic growth, and both Broadcom (AVGO) and Marvell (MRVL) continue to see very strong demand in data center and enterprise networking.

Underlining that demand, Ciena posted a book-to-bill of 2.5x in the first quarter, and even if that was boosted by some limitations on the “bill” part, the book-to-bill would have still been 2.3x if Ciena had hit the high end of its initial revenue guidance range for the first quarter. With that, the backlog stands at over $3B, or about three-quarters of expected FY’22 revenue.

The Outlook

Ciena isn’t out of the woods yet on supply chain challenges, and management did modestly guide second quarter revenue down – about 1% below the sell-side average. Management also guided gross margin lower, but I believe that could be a by-product of mix as well as supply chain cost pressures. With those pressures, FY’22 is shaping up as a weaker year for operating leverage, but I do still expect a meaningful ramp later this year and across FY’23 and FY’24.

I haven’t changed my revenue estimates much at all at this point, as I think management can hit its goal of recouping these lost sales later in the year. Longer-term, I’m still looking for annualized revenue growth of more than 6%, with Ciena leveraged to a strong near-term capex cycle among telecom providers, cable providers, and data center operators. I also see share-growth opportunities in Europe (where the company has historically been weak) and opportunities to gain share with a refreshed offering in enterprise routing and switching.

My FCF margin estimate for FY’22 is now two points lower due to the weaker operating leverage outlook and the inventory build-up. There could be some upside in FY’23/FY’24 as working capital normalizes, but I’m being slow with making that change. Still, over the long term, I expect mid-teens FCF margins and FCF growth of around 8%.

The Bottom Line

Between discounted cash flow and margin/growth-driven EV/revenue and EV/EBITDA approaches, Ciena still looks undervalued to me, and substantially so. I believe these shares should trade in the low-to-mid $70’s now, with long-term total annualized return potential in the low double-digits.

Given the combination of significant growth in data traffic and equally significant capex spending growth to service/support that traffic, strong market share, and growth opportunities in areas like routing/switching and software, I continue to believe that Ciena is a name well worth considering.