Ciena Stock: Technological Leader In A Secular Growth Market (NYSE:CIEN)

Investment Thesis

Ciena (NYSE:CIEN) is the technological leader in the coherent optical space, with a track record of outpacing the competition both in terms of product innovation and market share in the last 8-10 years.

The company should benefit from the general rising capital investment trend among internet content providers, as well as the need for telecom service providers to upgrade their systems. The emergence of AI / ML should eventually also drive demand for Ciena’s products.

There is room for margin expansion with supply chain issues abating, larger scale and less competition going forward.

The company is trading at 15x P/E based on 2024 adjusted EPS. An acceleration in business from H1 2024 onwards should drive earnings improvement and subsequently investor interest in the stock. Buy.

FY 2023 Review

The optical equipment maker’s stock lost around 14% year to date, significantly underperforming both the general market and the broader technology industry. Sentiment was negative as Ciena’s prospects suffer from dampened demand of telecom service providers due to built-up inventory levels. Furthermore, given the general focus on AI companies prioritised investments in computational power rather than optical equipment.

The company published its full-year results (fiscal year ending in October) on Dec 7, beating the guidance they had given at the end of 2022. FY 2023 sales increased by 21% (guidance: 16-18%), adjusted gross margin stood at 43.5% (guidance 42-44%) and operating expenses amounted to $1,333 million for the year (slightly exceeding guidance of $325 million per quarter).

Following the results, Ciena’s stock decreased as sales growth guidance for 2024 (midpoint of 2.5%) was probably disappointing. However, the company reiterated its longer-term growth expectations of 6-8% sales CAGR between 2024 and 2026. This implies an acceleration to around 10% in both FY 2025 and 2026. The subdued expectations for 2024 are caused by anticipated lower demand by telecom service providers. Management is confident that demand will bounce back by mid of the year, though. Contrary, orders from direct cloud providers are expected to remain strong, Q4 2023 was the first quarter where non-telecom customers represented more than 50% of total revenues.

In addition, international markets should prove resilient in 2024. Sales in the Asia Pacific market (including India – currently the fastest growing internet market) increased by 46% yoy in Q4 2023, and revenues in EMEA grew 21% in Q4. Another growth area is the Routing and Switching business, a relatively new market for Ciena with sales of $500 million only in 2023 but growing by 27% compared to 2022.

Sales And Margin Upside

Demand for internet bandwidth has increased by around 30% per year over the last 2-3 decades. Ciena capitalized on this trend, growing its revenues by almost 80% between 2014 and 2023 (7% CAGR). The equipment maker outpaced the competition by introducing several “firsts” in terms of wavelength per second capability in the optical systems market and grew its market share (global ex China) to 29% in 2023.

The company should further benefit from the general rising capital investment trends in the market. The general expansion in bandwidth demand and the need to reduce power consumption will require system upgrades over time. Hence, orders from their traditional customer base should pick up again. Direct cloud providers have gained significantly in importance and are expected to remain drivers of future sales growth.

The relatively new Routing and Switching segment as well as international markets (EMEA and APAC represent around 30% of total sales, with the remainder generated in the Americas) provide further growth potential. Sales in EMEA could receive a boost once service providers initiate the expected replacement of Huawei equipment in their infrastructure due to security concerns. While India was early in transitioning away from Chinese suppliers, management expects replacement activity to pick up in Europe in 2025.

On top of the existing business, Ciena expects its total addressable market (TAM) to expand from $13bn in 2020 to around $22bn by 2030 led by the roll-out of fiber broadband access.

Another upside to the business that is not included in the company’s long-term revenue guidance of 6-8% p.a. is a rise in bandwidth demand caused by the broad adoption of Artificial Intelligence / Machine Learning. So far, AI has led to a massive increase in traffic within the data center but has not impacted the overall traffic outside of the data center. This will likely change once data centers are connected to each other. Some research analysts predict AI could lift the annual growth rate in bandwidth demand from 30% to 35-40%. Additionally, the surge in traffic within the data center creates a need for an enhanced internal transmission system, an area where Ciena could leverage its expertise and expand the company’s addressable market further.

Finally, there is scope for margin expansion with the supply chain environment normalizing, the company further scaling up and shifting the product mix towards higher margin products. With one main competitor being absent in competitive bidding processes, Ciena should be able to return to pre-pandemic operating margin levels that were in excess of 17%.

Valuation Considerations

The table shows Ciena’s reported financials and three years of our forecasts centered around the company’s long-term guidance. 2024 numbers are based on Ciena’s expectations of a midpoint sales growth of 2.5% and an adjusted gross margin of 45% (mid-40s guidance). Predictions for FY 2025 and 2026 assume an acceleration in sales growth to bring the 2024-26 sales CAGR back to the expected long-term trend of 6-8%. The company has given a long-term adjusted operating margin range of 15-17%. We assume the lower end of the range is achieved by 2026. For 2025 we expect an adjusted operating margin of 14.5%. Based on these assumptions, Ciena should deliver EPS of $3.64 which is in line with research consensus. 9% sales growth in FY 2026 and an operating margin of 15% yield 2026 EPS of $4.19 slightly ahead of consensus of $3.94.

At $43.49 (closing price Dec 15, 2023) Ciena is trading at around 15x 2024 adjusted EPS. Rolling 12 months forward and applying the same multiple would result in a 12-month share price target of $54.55 for the stock.

Assuming revenues do not accelerate in 2025 but only grow at 2.5% again and keeping the operating margin at the 2023 level will reduce expected EPS to $3 (conservative case). Based on 15x adjusted EPS, this would result in a fair share price of $45 or around the current share price level. If sales growth increases to 15% and the company achieves 15% adjusted operating margin by 2025, EPS would increase to $4.23 putting the implied share price target at $63.45 (upside case)

These cases are all based on a 15x P/E multiple, while Ciena has historically traded at a higher multiple. The 5-year average multiple has been around 19.6x, the median at 19.1x. The median might be more meaningful, as it reduces the impact of the distortion during the pandemic phase in 2022. Given their competitive position and technological edge, there is potential scope for a re-rating of the multiple.

Risks

Earnings development could disappoint if orders from telecom service providers do not come back as expected or growth in the direct cloud provider segment stalls. While the long-term margin target looks achievable compared to Ciena’s pre-pandemic profitability, there is still some way to go. This is especially true as the company acknowledged that they will not return to a just-in-time supply chain they were running before. Additionally, any new disruptions to the supply chain could impact or delay the expected margin improvement. While Ciena is the technological leader in the optical equipment markets, it still faces tough competition. Competitors like Nokia could bid aggressively on new businesses to win back market share. Furthermore, the company is determined to expand its total addressable market by broadening its product portfolio, this does not come without the risk of misallocating resources.

Final Thoughts

In conclusion, Ciena is operating in a secular growth market and has proven its technological leadership for years. The company’s profitability suffered in recent years due to supply chain distortions caused by the Covid pandemic. Normalising supply chains, growing importance of direct cloud providers, less competition due to national security concerns as well as additional potential caused by fiber broadband rollout and AI should drive both top and bottom line growth in the years to come. These factors do not appear to be properly reflected in the current valuation. Buy.