Highlight of the 3/7/02 ML report
We believe the negatives outweigh the positives for Ciena, as we expect the outlook will deteriorate further before a recovery. Therefore, we are reinitiating coverage with an intermediate term Reduce/Sell and a long term Neutral.
Negative factors: customer concentration, key customers slashing spending, excess network capacity, increasing competition, and operating expenses out of line with sales.
Positive factors: established leading product line, respected management team.
We expect the outlook to deteriorate further and expect the company will need to take further action to address costs and sales wins.
An eventual recovery is expected as Ciena has substantial cash and a respectable market stature, yet we only expect demand to turnaround in late 2003/early 2004.
Lastly, we think CIEN’s valuation is demanding. Even under a bullish scenario of $1bn in sales and a 42% gross margin level (vs. 2002E levels of $481mn and 14.6%), our model yields EPS of $0.05, which implies a 197x 2004 P/E. We would rather target the 30-35x range.
We believe Ciena’s fair value is $5.3/share, based on a net cash level plus 30x normalized 2004 EPS. Alternatively, one may consider Ciena’s 4.5x EV/Sales (2002) compared to the wireline group average multiple of about 2x.
The sales outlook for Ciena appears very uncertain, but its substantial cash position and product portfolio support the company in an eventual recovery. Carrier spending continues to look grim, and Ciena’s customer concentration amplifies the affect. Although Ciena announced a restructuring on February 5th, we expect the company to undertake additional actions.
We believe that the combination of reduced carrier spending by about 22% in the US in 2002 and excess capacity in the optical network bodes poorly for Ciena for at least the next year. Key customers, Qwest and Sprint have recently reduced spending expectations.
We are also concerned that the spending environment will continue to deteriorate. Our current model expects 2003 global capex to decline by 3%, yet it seems like the recent reductions in spending of key carriers in the US as well as a beginning of negative spending patterns in Europe and Asia hint that a recovery is not around the corner.
We also highlight low utilization rates of the optical networks. Our model shows that excess supply of bandwidth only clears in late 2003 or early 2004, and Ciena’s legacy long haul WDM and switching equipment is expected to suffer the most from this network capacity glut.
We believe that the enterprise value to sales ratio of 4.5x 2002E is a bit rich. The wireline group is currently trading at 2x.
What if we are wrong and investors are willing to pay a hefty premium for a leading position in the optical networking space? We believe Ciena’s stock could benefit by the following events; however, we view all of these as unlikely in the intermediate term. We have listed them in order of likelihood.
• Selection, announcement and meaningful deployment by MCI, Sprint, or other global carrier for CoreDirector beginning in 2002.
• An early closing of the ONI Systems acquisition.
• Contract win that would generate over $100 million in additional FY02 sales.
• Restructuring that would result in halving operating expenses and restoring gross margins above 35%.
• RBOC selection for the MetroDirector K2 as a primary solution for next generation SONET.
We believe many of these events are possible, but not until
2003 at the earliest. Given the current stock price ombined with unlikely catalysts for support, we feel the current valuation is unwarranted.
We believe investors should be cautious, as it seems like Ciena’s valuation does not fully reflect the risks, concerns and new P&L trends. We rate the Company Reduce/Sell.
We are mostly concerned with the recent decline in Ciena’s revenues and the impact on its margin level. Ciena’s most recent quarterly financials, which were reported on February 21, 2002, highlight the fact that the collapse of the optical systems market has caught up to the company with a vengeance. We still consider Ciena a key player, but recognize that its history of customer concentration has tended to amplify its performance. We believe that Ciena’s plan to acquire ONI systems makes sense for the company; however, for financial modeling, we will not include the affect of the merger.
In the January quarter, Ciena reported sales of $162.2 million, a 56% decline from the $367.8mn reported last quarter and 54% below the $352.0mn reported last year. The immediate impact was a sharp decline in gross margins, which dropped to 13.9% from 39.8% recorded in the last quarter and 45.5% reported in the same quarter last year.
Although we do not have a crystal ball to pin point the exact steady state revenue level, given the state of the optical networking market and the spending patterns of Ciena’s key customers, we could certainly foresee a scenario in which the company reports more sequential revenue declines.
The company has undergone some restructuring, but we believe there is more to come. The most recent actions will include cutting about 400 jobs and taking a $9-$11 million charge. Considering our projected sales levels and specifically weakness in long haul transport, we expect Ciena will need to undertake further cuts to reduce costs by half and achieve gross margins over 40% to return to
profitability. As mentioned, the last quarter gross margin stood at 13.9%, operating expenses were 107% of sales and 837% the gross profit levels. Therefore, in our view, the suggested $10mn reduction in operating expenses is just the tip of the iceberg. Furthermore, we anticipate that Ciena will write-down inventory of long haul components given that
inventories are currently 2.5x expected April quarter sales of all products. would not be surprised to see additional staff cuts and charges to reduce expense levels. We expect Ciena will end FY02 with about $2.94 in net cash per share ($1.5bn in cash and $712mn in debt). The annual cash burn rate is expected to decline from the current $0.72/share to about $0.5-0.6.
Lack of Customer Diversification
A lack of true customer diversification has rocked Ciena’s outlook following nine quarters of year-over-year doubledigit growth; Ciena has faced a setback. For the past four fiscal years, Ciena has generated nearly half of its sales from two or three customers. (Sprint, Qwest and Ebone). So Ciena’s prospects in the near-term are more about
the spending patterns of existing customers and its ability to win new customers than it is about the industry as a whole.
In the January quarter, Ciena had two 10% customers. We believe one was AT&T and was exclusively for the purchase of CoreDirectors. The other was probably Sprint, but might have been Qwest. In the intermediate term, we expect purchases from Qwest and Sprint to be minimal, and AT&T will likely continue as a 10% customer. We believe AT&T will continue its roll-out in upgrading its network to a total of 100 cities. We believe that systems have been deployed in 40 cities and are interworking with Cisco’s 15454. We estimate that the revenue to date is in a range of $40-$60 million, and represents a potential annuity tream as the systems are probably lightly loaded. The total build should provide over $100 million in sales for Ciena. Although we know that the K2 was unavailable when AT&T began
evaluation, we must watch to see if Ciena can pull-through sales of its MetroDirector K2 against Cisco’s 15454. We are left with the question of whether Ciena eventually displaces Cisco or vice versa?
Overall we expect sales to decline 70% YoY in 2002, and also highlight the risk the numbers could still come below our model, as we have modeled a mini-recovery in 2H2002, with sequential growth of 20% and 15% in September and December 2002 quarters, respectively. In addition, we do not envision a profitable quarter until the end of 2004.
Ciena has a base of 62 customers, 41 of which provided revenue in the January quarter. Unlike many of the start-ups that have had their fortunes dashed without tier-one accounts, Ciena has a foothold in several potentially lucrative carriers including AT&T, BellSouth, Cable & Wireless, Qwest, Sprint, Tycom, and Verizon. However, we believe that the near-term outlook is only positive for AT&T’s spending on its ongoing CoreDirector deployment.
Ciena got its start with long haul WDM, which represented about 76% of sales in FY01. As a matter of fact, RHK recently reported that Ciena was the top provider of WDM in North America last year. Unfortunately, this strength came largely due to Ciena’s customer concentration with Qwest and Sprint, both of which will seriously slash spending in 2002. We now expect Ciena’s long haul sales to decline 90% and represent only 25% of sales in FY02.
We believe Ciena’s long haul offerings provide carriers with leading edge technology based on software control of amplifiers and filters built in house allowing for leading performance, all linked with a network management offering. However, we believe that several factors are working against Ciena in this product category: cuts in carrier spending, few new long haul builds, excess network capacity, and the emergence of credible contenders. The long haul WDM market, where Dell Oro reports Ciena as the number two player close behind Nortel in 2001, will decline dramatically for a second year in a row. We believe the long haul optical systems market will be down about 33% in 2002, and market researcher Dell Oro forecasts long haul WDM will be down 24%. We expect the competition to be fierce given the shrinking pie. Unfortunately for Ciena, without any new builds planned by major carriers, and its current base of customers adding little capacity, we expect to see share erosion in 2002. Our model for the overall optical systems space suggests that Ciena could lose over 3 points of market share to retain just over 2% of the market.
Ciena’s prospects over the next year are largely dependent on strength in its optical switches, CoreDirector and CoreDirector CI. We expect Ciena will retain its crown
but as several others enter the segment with new products (Corvis, Lucent, Nortel, and Alcatel), we expect Ciena’s share will stabilize between 30% and 50% depending on how much traction competitors can achieve.
Ciena is currently the unquestionable champion of the optical switching segment, a space it defined through its 1999 acquisition of Lightera for $464 million in stock. We believe Ciena took 45% share in the optical switching market, which includes competitors: Tellium, Sycamore, Corvis, Lucent and Nortel. We expect Ciena to grow this product at least 10% in 2002. Ciena’s prospects over the next year are largely dependent on strength in its optical switches, CoreDirector and CoreDirector CI. We expect Ciena will retain its crown, but as several others enter the segment with new products (Corvis, Lucent, Nortel, and Alcatel), we expect Ciena’s share will stabilize between 30% and 50% depending on how much traction competitors can achieve.
Through its March 2001 stock acquisition of Cyras, Ciena entered the relatively attractive next generation SONET/SDH segment. Note that Ciena refers to this product, now called the MetroDirector K2 as a metro switch. In terms of market segmentation, we classify this product as a next generation SONET/SDH system or as a Multi-Service Provisioning Platform (MSPP). Although this may seem like subtle semantics, some may struggle to recognize that the list of competitors includes the Cisco 15454, Lucent DMX, Fujitsu FLASHWAVE 4000s and Nortel Optera 3000s.
The next generation SONET/SDH space remains quite crowded. We see the MetroDirector K2 competing against established players in this segment, and we believe the product offers attractive features. However, we expect the bulk of sales go to incumbent vendors (e.g, Alcatel, Fujitsu, Lucent, Nortel) with gains made by Cisco. We are still optimistic that this product can show growth, but its contribution to sales will remain minimal. We now expect sales of about $50 million in FY02. We believe that the MetroDirector K2 offers highly competitive features, but we are uncertain if the edge is sufficient to displace incumbents. We expect that large carriers, including the RBOCs will continue to migrate to this category of optical system as it displaces legacy SONET/SDH systems, but we expect the transition to be
gradual, with the RBOCs moving in earnest towards the end of 2002 or early 2003. We do not believe the product has made the short list at any RBOC at this point and we feel that the lack of traction with customers should raise a caution flag. As mentioned previously, AT&T’s award to Ciena for the CoreDirector contract, while giving Cisco the MSPP portion grabs our attention.
Ciena’s metro WDM segment is in flux following Ciena’s announced intent to acquire ONI Systems. We believe the acquisition makes strategic sense to both companies, but the best we can say is that the market for metro WDM systems is just “less bad.” During 2001, Ciena lost market share to other players in the metro WDM space, as we believe its product has become dated. Prior to the announced deal with ONI, we suspected Ciena was developing a fresher metro WDM solution. We believe that the expected merger with ONI systems clearly addresses the gap on a more timely basis. We believe that the combination of ONI’s product into Ciena’s portfolio pushed with Ciena’s channels makes for a good match. We believe that in the near-term, Nortel presents the greatest threat as a direct competitor, but over the next year, we expect next generation SONET systems and metro DWDM crowded. However, we expect the solutions from Cisco, Fujitsu, and Lucent to represent serious threats to Ciena’s prospects. Delays in carrier spending are providing competitors with the opportunity to catch up.
Based on features, we believe ONI leads in technical appeal to carriers particularly for access rings. Within the enterprise space, Nortel continues to have dominant indshare. This may stem from several factors: originally designed for enterprise, first to market, sales through IBM. ONI has introduced a series of tributary options (100 Mbps
- 2.5 Gbps tunable interface, ONWAVE ESCON and ONWAVE 192/STM64) and other features (e.g., variable gain amplifier, dispersion compensation module) that enhance the products’ position.
On February 18, 2002, Ciena announced its intention to acquire ONI Systems at a value of approximately $900M.
The incentives for Ciena are obvious. Its metro WDM product had been getting stale, and we had expected an update by the end of 2002. Metro remains relatively attractive as we expect Ciena’s long haul sales (Ciena’s primary source of sales in 2001) to decline 90% in 2002. A well-designed metro WDM solution complements Ciena’s strong position in optical switching and its emerging next generation SONET/SDH solution.
The incentives for ONI are also clear. The company has solid technology, yet its operating expense ratios are way too high. We did not see the company becoming profitable until 2004. With the key customer, Qwest, cutting spending plans, ONI faces challenges in improving its customer mix. Ciena has sales to AT&T, BellSouth and Verizon already, and perhaps could pull-through ONI’s products as well, especially since ONI has completed significant portions of OSMINE (the program needed for RBOC deployment). Three companies dominate the metro WDM market: Nortel (42%), ONI (28%) and Ciena (17%). We expect this market to grow about 3% in 2002 to just over $700 million. The acquisition makes Ciena the largest company in the metro WDM space.
The combined company will be able to save on R&D and S&M costs, as they go after the similar customers and the solutions are similar. Ciena expects the deal to have neutral affect on earnings in CY02 and be accretive in early CY03.
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Hope you like this. I like authors Tal Liani and Simon M. Leopold macro view of the sector. I own CIEN so watch the report hurt the stock. I plan to cut out if hits $8.00.
Jack |
