elecommunications Equipment
Optical Components June Quarter Preview
July 15, 2002 SUMMARY
* Our recent round of field checks suggests that the June
Timothy Anderson quarter is likely to be a rather difficult quarter for
most photonics players. This comes as no surprise given
the difficult telecom backdrop and the pre-announcements
this quarter out of LU, NT, and CIEN/ONIS.
* Furthermore, our contacts suggest the outlook continues
to deteriorate mildly. We are hearing volumes remain
weak. Most of our contacts are saying prices on
photonics are not generally out of bounds, but the fear
is as demand picks up, fierce competition from oversupply
will causes prices to rapidly erode.
* In a nutshell, the picture looks unchanged from past
quarters. We remain on the sidelines with all companies
in this space, incl. AVNX, GLW and JDSU.
* We have also updated our valuations and risk
disclosures resulting in a trimming of price targets for
JDSU (to $3), GLW (to $4), and AVNX (to $3).
SUMMARY VALUATION AND RECOMMENDATION DATA
Earnings Per Share
Company (Ticker) Price FYE Rating Target LTGR Current Yr Next Yr
Avanex Corporation- $2.13 Jun Curr 3S $3.00 NA ($0.46)E ($0.26)E
(AVNX) Prev 3S $4.00 NA ($0.46)E ($0.26)E
Corning Inc. (GLW) $3.72 Dec Curr 3H $4.00 15% ($0.30)E $0.12E
Prev 3H $5.00 15% ($0.30)E $0.12E
JDS Uniphase (JDSU) $3.55 Jun Curr 3S $3.00 20% ($0.12)E ($0.05)E
Prev 3S $6.00 20% ($0.12)E ($0.05)E
OPINION
In our opinion, the outlook for optical components in the June quarter is for
continued difficult conditions. Driven by weak conditions at Lucent (LU, 3S
by Henderson--$2.56), Nortel (NT, 3H by Henderson--$1.45), and Ciena/ONI
Systems (CIEN, 3S by Henderson--$5.56), we think photonics makers are likely
to struggle to meet June quarter numbers. Furthermore, we expect most to
guide the top line modestly lower into the September quarter. Our views are
based on our recent checks, which turned up the following points:
* Field Checks Continue To Indicate Optical Demand Is Weak And Still
Gradually Eroding. Our recent field checks turned up evidence that the
photonic outlook remains challenging. Demand is low, with anecdotal
indications of order lot volumes in the 50-100 piece range compared to
tens-of-thousands of units per order lot during the peak. Our contacts
suggest optical component demand has continued to erode quarter to
quarter. Looking out into September, our concerns are raised about
further gradual erosion, rather than stabilization. On the pricing front,
price pressure appears fairly benign, with prices in June off the typical
20% year over year. However, our contacts fear when volumes start to
inflect, prices are likely to take a hit as photonics makers are likely to
intensely vie for business.
* Equipment Makers Appear To Be Reducing R&D Expenditures On Optical
Systems. Our contacts in the wireline equipment market suggest the recent
R&D cutbacks at companies like Lucent, Nortel, Alcatel (ALA, 3M by Davies-
Jones--$6.35) are eating into new equipment design activity and programs.
The net result, is we think this slow down continues to suggest difficult
times are ahead for photonics makers who have to compete for a shrinking
number of systems, further raising the specter of price pressure when
volumes begin to return.
* Inventories Remain A Problem. Our contacts are also indicating
photonics inventories remain high on both active and passive photonics and
that usage of written down inventories has been minimal. Estimating
inventories has become problematic. The low demand and poor
characterization of the write-downs at equipment OEMs obscures the
picture. On a global basis, we roughly estimate the total write-downs of
optical equipment at around $4-$5 billion. Using historical gross margins
in the 40%-45% range, this equates to roughly $7-$8 billion in equivalent
sales dollars. Historically, the optical component content in a system
was roughly $0.25-$0.30 to the dollar. This implies equipment makers have
written down roughly $2 billion in photonics. We assume half of this
inventory is actually unusable, or obsolete. Also we think JDS Uniphase's
market share is now above 50%, and the company is likely to generate $1.1-
$1.2 billion in annualized sales. Combining data points, the math
suggests there is still around 2 quarters of inventory in the channel. We
recognize there is significant variability to this rough estimate. Yet it
still illustrates our point, that photonics inventories remain a problem.
Add In The Trouble At Carriers And We Think Investors Have Ample Time To
Review Investments Before Deciding On A Move Into This Category. At the
carrier level, the June quarter was characterized as another quarter of
capital expenditure cuts. Looking forward, the Telecom Services Team expects
conditions to remain soft, and spending levels to be gradually cut into the
2H of the year. The end result is we see no meaningful recovery shaping up
for photonics names. We believe investors have time to continue to evaluate
the space. Recognizing the low interest and depressed share prices, we
expect most of the names are likely to trade sideways through this earnings
cycle.
VALUATION REVIEW -- ADJUSTING PRICE TARGETS FOR PHOTONICS NAMES
Corning---Lowering Price Target To $4 Per Share From $5 Per Share. We have
derived our price target based on a forward multiple expansion to current
sales multiple levels. Corning currently trades at 0.9x 2002 sales and 0.8x
2003 sales. Assuming the company hits its restructuring targets, we think
over the next 12 months the company can easily expand its multiple toward 1x
sales. This implies a price target of $4 per share. Corning is losing money
and in the midst of a significant restructuring. As a result, we do not
think using a price to earnings valuation metric is appropriate. We also
have used a discounted cash flow analysis to evaluate the price target. This
analysis, net of cash and debt on the balance sheet, suggests the name is
fully valued at around $4-$5 per share. While this number is close to our
chosen price target, we note over 50% of the implied valuation is driven by
the calculated terminal value.
JDS Uniphase---Lowering Price Target To $3 Per Share From $6 Per Share. We
have set our price target using a number of different methods including
enterprise value to sales, enterprise value to earnings per share and a fair
value analysis based on a discounted cash flow. In our opinion, the least
meaningful of these analyses is the enterprise value to earnings analysis.
Our rationale is JDS Uniphase is in the midst of a down cycle, where high
inventories and low profitability mask margin leverage potential resulting in
depressed earnings. We favor the other two analyses. On an enterprise value
to sales basis, the company trades at 1.8x trailing, 4.3x current and 3.2x
forward sales. Excluding the company's $1.15 per share cash balance suggests
the company trades at 0.9x trailing, 2.6x current and 2.0x forward sales.
Simple expansion of the forward multiple to current rates implies a price
target of $3- $4 per share. Our discounted cash flow analysis suggests the
company is fairly valued at $2-$3 per share. As a result we have set our
price target at $3 per share.
Avanex---Lowering Price Target To $3 Per Share From $4 Per Share. There are
few catalysts on the horizon for optical components vendors, and Avanex is
among the smallest players with little product depth, in our view. As a
result, we see little growth potential on the horizon over the next several
of quarters. Avanex has a substantial cash balance. Including the cash from
the pending merger with Oplink (OPLK, Not Rated), we estimate Avanex will
have around $350 million in cash by the end of August. Factoring in the
combined company is not likely to burn more than $40-$50 million in cash over
the next several years, and we think this name is likely to trade around its
cash value. This suggests a target price around $3 per share.
RISKS -- OVERVIEW OF RISKS FOR PHOTONICS COMPANIES
Corning---Key Risk Remains Telecom Outlook And Balance Sheet Issues
We think the most significant near-term issues include soft
telecommunications capital spending budgets, a difficult optical fiber price
environment, and significant unutilized capacity in global optical fiber
manufacturing. Corning also has a number of non-telecommunications
businesses whose success generally tracks the macro economy. If the backdrop
for optical fiber erodes faster than our expectations, or if the U.S. economy
takes a double dip, the stock is likely to struggle to reach our target
price. Corning is also burning cash and has a highly leveraged balance sheet.
Management has reacted by restructuring operations. At this time, we think
the company has enough cash to meet its commitments. However, given the
complexity of analyzing the cash obligations, some investors may hesitate to
make greater commitments to this name. Also, if the company restructures
its balance sheet this would likely result in equity dilution that may make
achieving our price target more difficult.
JDS Uniphase---Key Risk Is Sluggish Optical Equipment Demand In Wireline
Telecom
A difficult wireline telecommunications carrier capital spending back drop
and high component inventories are the two key risks for this name. Forward
sales visibility for JDS Uniphase is low and has not improved for over a
year. We are forecasting gradual improvement in conditions. However, if
carrier spending on optical systems and equipment continues to deteriorate
beyond our expectations, or does not stabilize in the next 12 months, we will
likely have to lower our earnings outlook. A similar situation is likely to
result if current high inventory levels do not abate, or if optical systems
vendors sell a significant number of components out of written-down
inventories. Should such conditions arise, investors may continue to
hesitate to back this name.
Avanex---Key Risk Is Eroding Technology Leadership. Intellectual property
dilution is the key risk for this name. Avanex's R&D spending is minimal.
Over time competitors, whose R&D spending levels are higher are likely to
close the gap with any remaining intellectual property advantages. While we
believe expectations are low, and downside risk is minimized by a substantial
cash balance, a lack of customer demand could drive sales lower. On the
other hand, given sales in the $5-$10 million per quarter range, one customer
seeking to test a new optical component product would likely generate enough
sales from test products alone to generate a meaningful pop in top line
performance. Such activity is likely to cause this name to trade with high
volatility around our price target, in our opinion.
QUARTERLY ESTIMATES PER SHARE DATA
Current Year Next Year Next Year + 1
Ticker Period Current Previous Current Previous Current Previous
AVNX 1Q ($0.11)A ($0.11)A NA NA NA NA
2Q ($0.10)A ($0.10)A NA NA NA NA
3Q ($0.11)A ($0.11)A NA NA NA NA
4Q ($0.14)E ($0.14)E NA NA NA NA
Year ($0.46)E ($0.46)E ($0.26)E ($0.26)E NA NA
GLW 1Q ($0.10)A ($0.10)A NA NA NA NA
2Q ($0.10)E ($0.10)E NA NA NA NA
3Q ($0.08)E ($0.08)E NA NA NA NA
4Q ($0.03)E ($0.03)E NA NA NA NA
Year ($0.30)E ($0.30)E $0.12E $0.12E NA NA
JDSU 1Q ($0.03)A ($0.03)A NA NA NA NA
2Q ($0.02)A ($0.02)A NA NA NA NA
3Q ($0.03)A ($0.03)A NA NA NA NA
4Q ($0.04)E ($0.04)E NA NA NA NA
Year ($0.12)E ($0.12)E ($0.05)E ($0.05)E NA NA |
