Ciena Hit Hard On Softer Short-Term Demand Trends

It's all well and good to be a long-term investor, but the reality is that the market's intense focus on short-term results has a major impact on share price moves, and so it was with the post-earnings reaction in Ciena (NYSE:CIEN) shares. While there is little evidence here of any downgrade to the long-term growth opportunity (quite the opposite, really), order push-outs from service providers and hyperscale cloud operators are hitting near-term growth expectations.

Ciena still looks poised to exit the year with a robust backlog and data traffic growth continues to support a healthy long-term revenue growth outlook, supplemented by growing opportunities in newer areas like edge routing. Investors willing to look past a couple of lackluster quarters can reasonably expect healthy upside from here, but the market is likely to be more cautious until there is evidence of improved order activity from service providers and hyperscalers (likely a 2024 event).

Exceeding Raised Expectations In FY Q2

Ciena produced a beat-and-raise quarter when it reported back in March, and management subsequently exceeded those expectations in the fiscal second quarter. Guidance, though, was not as robust as hoped, though full-year expectations are still higher than they were at the start of 2023.

Revenue rose 19% year over year and 7% sequentially, beating expectations by about 4%. The beat was fairly broad, with only Software ex-Blue Planet coming in below published estimates. While revenue from telco customers (up 4% qoq) was better than expected, direct webscale (down 2% qoq) was softer.

Network revenue rose 25% yoy and 7% qoq, with 26% and 7% growth in the Converged business and 19% and 9% growth in the Packet (switching and routing) business. Overall software revenue rose 5% yoy and 1% qoq with a 22% yoy and 34% qoq improvement in Blue Planet. Service revenue declined about 1% yoy but rose more than 13% sequentially.

Gross margin improved 70bp yoy and was steady from the prior quarter at 43.7%, beating by 130bp. Product margin improved 150bp from the year-ago period on improved component availability, but did decline about 80bp qoq to 42.6% on mix. Service margin declined 150bp yoy and improved 390bp qoq to 49.1%.

Operating income rose 47% yoy and 18% qoq, with margin improving 250bp yoy and 120bp qoq to 13.8%. Operating margin beat Street expectations by over two points, with outperformance on all lines.

Softer Guidance Feeds Into Street Fears About Demand

The Street was nervous about this space for much of the year, with concerns both about softer spending from traditional telco and cable customers and weaker enterprise spending. Those fears weren't helped by Cisco's (CSCO) 23% product order decline in its last quarter, and Ciena has likewise become more cautious as management acknowledges order pushouts from service provider and hyperscale cloud customers.

To be sure, the magnitude of the revision isn't that large - management lowered its full-year revenue growth guidance to 18%-22% from 20%-22% - but it does suggest near-term weakness with both FQ3 and FQ4 revenue potentially below FQ2 levels and a pause in growth until the second half of FY'24.

I believe there are several moving parts to this near-term turbulence in orders. On the telco side, I expected capex to be weaker this year, and that's held true, though it would seem there have been more over-ordering than I'd anticipated (telco customers putting in higher orders than they really needed in response to component shortages). On the cable side, the pandemic pulled forward quite a bit of customer growth and that is driving an adjustment period.

The webscale side is perhaps more concerning to the Street. When I last wrote about Ciena I noted my concern that enterprise could be a source of weakness in 2023. That weakness seems to be spreading into Ciena's high-end hyperscale customers; some of this could be business lost to pluggables (to companies like Cisco and Marvell (MRVL)), but I believe it is more likely that Ciena is seeing customers redirect their spending toward AI-enabling capex. Sooner or later they will have to invest in optical capacity as well, but it's enough to undermine growth at Ciena for a few quarters.

The Outlook

A weaker near-term outlook is clearly not a positive for a what-have-you-done-for-me-lately Street, but the longer-term outlook is still quite positive. Not only is Ciena leveraged to what seems to be never-ending growth in data traffic, the company has been winning share on the back of new product/technology launches and Huawei replacements with customers.

I also believe there are still underappreciated opportunities here from share gains and expanding addressable markets. Ciena management believes that edge routing growth will drive an incremental $8B in addressable revenue opportunities over the next five years alone, and the company has only just started releasing IP optical converged products for the market; Cisco, Juniper (JNPR), and Nokia (NOK) won't simply roll over for Ciena, but I see meaningful opportunities here. I also think there are underappreciated opportunities for Ciena to gain share in ZR pluggables from Cisco and Marvell after some initial delays in product development/launches.

While I have revised my FY'23 revenue estimate modestly lower in light of guidance, it's still about 2% higher than it was at the start of the year. I'm also still expecting 7% or better revenue growth in FY'24 and FY'25 before growth moderates more toward the mid-single-digits; even then, further growth in edge routing, pluggables, and new market verticals (like defense) could drive upside, and I'm looking for long-term revenue growth close to 7% (or around 5.5% excluding the big jump in FY'23 revenue).

With margins, I expect operating margin to improve by more than two points in FY'24 and at least a point in FY'25. Drivers for this improvement include improving component supply, maturing new product commercialization ramps, and a more favorable mix away from line systems. At the free cash flow line, I still expect meaningful improvement over the next five years, with the FCF margin plateauing in the mid-teens.

Long-term discounted cash flow still supports a fair value in the low-to-mid-$60's. A shorter-term approach that uses margins and revenue growth supports a lower fair value in the $50's, but one that still offers upside from here even in the face of a few weaker quarters.

The Bottom Line

Investors need to make their piece with the fact that Ciena will likely always be more volatile than average, but looking through that volatility, the company has been steadily gaining share in its established markets and repurposing its technology (augmented by some relatively small M&A deals) toward new opportunities like webscale and edge routing. The nature of the business will likely lead to future boom-or-bust post-earnings reactions, but for investors who can tolerate that volatility, I believe the longer-term upside is still attractive.