“Buy the dip!”

Great advice, right? There’s just one problem – by and large, those “dips” don’t just come out of the blue. For a popular stock with an attractive underlying business, a meaningful selloff requires something that scares the Street, and usually what scares the Street will scare individual investors too.

Ciena’s (CIEN) significant reduction in guidance for the next quarter, and warning that the weakness would likely persist for a few quarters, was indeed scary, but I don’t think it changes the long-term outlook all that much. I think Ciena’s recent success likely attracted investors who weren’t as familiar with the business, and probably lulled more experienced investors into complacency, but the volatility from service provider accounts that Ciena cited is, historically, really not that unusual.

I don’t want to underplay the risk that Ciena’s guidance could still need to be revised further, and I won’t ignore the fact that the Street is a “what are you doing for me today?!?!” world where weaker near-term relative performance can be punished harshly. Still, I think the core of this business is strong, the growth drivers are still place, and the shares are now undervalued.

A Mediocre Set Of Results

Ciena’s fiscal third quarter report wasn’t bad, but it wasn’t exciting either – particularly in the context of the much weaker guidance. Revenue was basically in line, and a modest gross margin beat reversed to a small miss at the operating line.

Revenue rose 2% year over year and 9% quarter over quarter. Network platform revenue rose about 1% yoy and 12% qoq, with converged packet down slightly yoy and up 10%, while the smaller packet networking business grew 11% and 24%, respectively. Service revenue was basically flat, while software grew more than 20% and declined about 4% sequentially. Revenue from telcos declined about 3% yoy this quarter, while cable customer revenue rose 32%. Webscale (enterprise) customer revenue fell about 4%, but rose 14% qoq.

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Gross margin rose 350bp from the prior year and 130bp from the prior quarter, with good core profitability in the product and service businesses. Operating income jumped 40% yoy and 37% qoq, with operating margin up strongly (up 530bp yoy and 390bp qoq).

Ugly Guidance As Service Provider Volatility Returns In A Big Way

Ciena shocked the Street with a guide for the next quarter that was 18% below the prior sell-side average estimate and equivalent to mid-teens contraction both an annual and sequential basis. That was bad enough on its own, but it was arguably received even worse in the context of the company’s digital roadshows in June not really hinting at the magnitude of the problem – management mentioned “caution” among service providers, but the magnitude was definitely a surprise.

The big issue in the business is the company’s service provider business. In response to weakness in their own enterprise businesses, customers like Verizon (VZ) and AT&T (T) have gotten a lot more cautious with their own capex budgets. I don’t believe there has been a long-term fundamental shift, but service providers have had to step up their investments for edge bandwidth to accommodate the sudden increase in work-from-home demand. At the same time, the companies’ visibility into near-term trends amid COVID-19 is lousy. It also sounds as though some international customers, particularly in India, have meaningfully scaled back near-term capex.

Ciena’s leverage to service provider spending goes a long way toward explaining why Ciena’s guidance was weak while companies like Broadcom (AVGO) and Inphi (IPHI) still expect strength in their data center businesses. That said, Ciena’s revision of Webscale growth from 7% to 10% for FY’20 to “low single-digit-growth” is not a positive development. While the company did log a material win with a major customer for its WaveLogic 5 800G offering, there was a material slowdown at another customer (I’m guessing Facebook (FB)).

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A Challenging Period, But Not A Shift

With weaker service provider spending for a few quarters, Ciena’s growth is going to look lousy next year before a pickup in FY’22. I’m still not really worried about the long-term status of the business.

First, I expect the service provider weakness to be transitory; these companies have little choice but to continue to invest in optical systems, and I see no evidence yet that Ciena is losing share. In fact, Ciena has been a steady share-gainer over the last decade, and may yet have more share to gain over the next three to five years as European providers switch away from Huawei.

Second, headline wins with customers like CenturyLink (CTL), Windstream, and Telia (OTCPK:TLSNY) haven’t started contributing to reported results in a meaningful way. There will be negative margin consequences when they do (new business depresses margins given the product mix shift toward chassis, but then recovers as the mix shifts toward higher-margin line cards), but that will be recouped over time.

Third, I continue see strong growth potential in data centers. Ciena logged another six new wins for WaveLogic 5, the leading 800G offering, and while Infinera (INFN) is optimistic about their 800G offering, I believe Ciena’s only real risk is in customers decided to second-source just to hedge their exposures. I do have some concerns about the risk that Inphi’s (IPHI) strong ZR offering could pull business away from Ciena, but Ciena management has been adamant that they will be a strong competitor in the market and that the impact on the business will be modest. I think management may be “half-right” here – I think their ZR offering will be competitive, but I do also think ZR will prove to be a little more disruptive. Still, I don’t see it ruining the data center growth opportunity for Ciena.

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The Outlook

I suppose it was a good thing that my numbers were already below the Street averages, as there’s less change to my outlook and fair value now after this guidance update. My revenue number goes down about 4% for this year, 10% for next year, and 6% for FY’22, but I also see some upside here, as I do believe that service provider spending will recover as COVID-19 eases and market visibility improves. Long term, I still expect Ciena to generate mid-single-digit revenue growth, with better margin consistency driving FCF margins into the mid-teens and driving high single-digit FCF growth.

Between discounted cash flow and margin-driven forward multiples, I believe Ciena is now priced for double-digit long-term annualized returns for shareholders.

The Bottom Line

I expect that Ciena is going to be shunned by growth investors for a while, and who knows what the near future holds for a tech market (and overall stock market) that I already thought was expensive. Specific to Ciena, this revision is clearly negative, but it doesn’t really change my view beyond a couple of years, and I think this is a pullback that patient, risk-tolerant investors should look at as an opportunity.

Disclosure: I am/we are long AVGO. 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.



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