OT - CIEN
Thought this was an interesting report on optical.
From Citi.
OPINION
LH DWDMAnd Optical Switching Start-Up Infinera Has Building Market Traction
Including Potential Opportunity In BT 21st Century Network
Infinera is a Sunnyvale, California based venture-backed start-up that has raised over $200
million in funding and has ramped its revenues to around $25 million per quarter since it
first started shipping product in December 2004. The company is unusually vertically
integrated in that it produces a proprietary Photonic Integrated Circuit (PIC) its own fab and
uses this chip as the foundation for its uniquely architected DTN optical transport and
switching platform. Yesterday, in London, the company unveiled a new PIC with 1.6Tbps of
transport capacity on a single chip. Also yesterday in London, in a separate meeting, BT’s
CTO told an Editor at online industry magazine LightReading.com that “he's monitoring
Infinera's developments closely and that it's possible the company's technology could
become part of the carrier's next-generation network, the 21CN” according to a story on
LightReading.
Infinera’s Ramping Success, And Especially The Potential In BT 21CN, Is Negative For
CienaWhich Has High Exposure To LH DWDMAnd Optical Switching. Over 45% of
Ciena’s revenues come from LH DWDM and optical switching. According to the Dell’Oro
Group, as of CY 4Q 2005, Ciena was the #7 market share player in LH DWDM with 7.4%
market share. However, the LH DWDM market is more important to the investment case for
Ciena than its #7 market position would suggest because the top 6 market share players are
all diversified telecom equipment players with optical businesses that make up under 10% of
their overall sales. As investors have become more optimistic on the prospects for the
optical market, they are viewing Ciena as a more pure-play investment vehicle with which to
invest in the market.
While Dell’Oro does not yet break out Infinera as a separate competitor, but instead notes
that it makes up the bulk of the “Other” category, we believe Infinera was likely the #9
player in the market from a revenue perspective in 4Q and will likely pass Marconi in 1Q
2006 to become #8 in market share just slightly behind Ciena. We should also note that
Dell’Oro credits Infinera with #1 market share from a 10G port shipment perspective with
26% in 4Q, up from 20% in 3Q. However, this metric is misleading due to Infinera’s
architecture for two main reasons. First, where other vendors put one 10G port on each line
card, Infinera’s integration allows it to fit ten 10G ports on each line card. In addition, other
vendors try to avoid Optical-Electric-Optical (OEO) conversions, since they are traditionally
expensive, and use ultra longhaul optical technology to avoid OEOs. Infinera, on the other
hand, has made OEOs cheap and typically places additional systems/line cards every 200km
along a route. Therefore, where a traditional optical vendor may place 2-3 systems along a
2000km route, Infinera is likely to place ten systems or 3-5 times as many boxes along the
same route, but still at a significant overall GB/km price discount relative to the traditional
vendors.
• Infinera’s Unique Technology Has Potential To Disrupt Pricing And
Competitive Environment For Incumbent Optical Systems Vendors.
While still in the fairly early stages in terms of commercial deployments, we
think privately-held Infinera could potentially become disruptive to the pricing
and competitive environment for LH DWDM and Optical switching systems
vendors such asALA, CIEN, LU, NT, and SCMR. Infinera has six announced
customers (Level 3, XO Communications, FLAG Telecom, Citynet, OnFiber, and
freenet) and several unannounced customers. Given the compelling operational
and cost advantages of the Infinera DTN system, we believe Infinera will likely
eventually penetrate Tier 1 incumbent carrier networks and could begin to
pressure the pricing and growth rates at the larger vendors. We estimate Infinera
offers carriers the same capacity as the traditional vendors at roughly 50% of the
price, with ongoing OPEX at least 50% below and more flexible service delivery
options.
• Latest Comments From BT Regarding Infinera AndWillingness To Pay For
Equipment EspeciallyWorrisome For Ciena. Over the past couple of days,
top BT execs have noted that while it has already selected Huawei and Ciena as
its 21CN optical transport vendors, there is room in the project to add additional
innovative vendors like Infinera. At the BT 21C CommunicationsWorld Forum
today, the CEO of BT’s Wholesale Division stated described the process of
bargaining its vendors down to rock-bottom prices as engaging in "the most nonsympathetic
vendor procurement process" in the industry. We note that Ciena
already is competing with Huawei for business in the 21CN project and the
addition of Infinera would add even greater pricing pressure.
• We Think Ciena Looks Overvalued At Current Levels,Which Assume
Aggressive Growth RatesAnd Perfect Execution. We think the valuation and
the expectations for Ciena appear quite high. The consensus estimates call for
25% revenue growth in FY 2006 and 19% growth in FY 2007 with most of the
expected growth coming from the BT contract. We think this makes Ciena
susceptible to any deviations in timing or volume of orders from BT as well as
any new competitive challenges in the account, such as the introduction of
Infinera. While Ciena is expected to finally hit break-even in the July 2006
quarter, we note the stock is currently trading at 44x normalized CY 2006
earnings assuming 15% operating margins. We think this is a very rich multiple
for a high risk story with high expectations already built in.
2
Infinera Has Translated Its Proprietary Photonic Integrated Circuit (PIC) Technology
Into A Highly Flexible And Cost Effective DWDM System. Sunnyvale, California-based
Infinera was founded in 2001 with $50 million in funding from Kleiner Perkins Caufield &
Byer and a management team including former JDSU and Lightera (acquired by Ciena,
became the CoreDirector or Core Switching Division) executives. Before building an
optical transport system, Infinera began by designing a proprietary and cutting edge PIC.
This chip, which Infinera manufactures in its own fab, includes a 100 Gb/s transmitter,
which integrates ten lasers, ten 10 Gb/s modulators, and an optical multiplexer; as well as a
100 Gb/s receiver, which integrates an optical demultiplexer and ten photodiodes. Each PIC
enables low-cost optical-electrical conversion on a semiconductor chip no larger than 5mm
on a side and allows the DTN system to pack ten 10G wavelengths on each transceiver card
or port versus typically one wavelength per card/port for other vendors.
• Unlike Other Optical Systems That Strive To Reduce OEO Conversions
Through ULHAnd All-Optical Switching – Infinera Does Low Cost OEOs At
Every Node, Thereby Increasing The Flexibility Of The Network. Since
Optical-Electrical-Optical (OEO) conversions have been quite expensive
historically, traditional optical networking systems have attempted to reduce OEOs
by employing ultra longhaul (ULH) DWDM transport and all-optical switching
(failed start-ups like Corvis and Tellium), and more recently ROADMs
(reconfigurable optical add/drop multiplexers). The downside of the all-optical
approach is that traffic cannot be groomed below the wavelength level in the optical
domain and until recently, with the advent of ROADMs, adding/dropping or
switching traffic has been inflexible. Because traditional optical systems vendors
strive to minimize the electronic in their networks, optical systems management
tends to be analog rather than digital, which by its nature is more inflexible and
costly than digital management.
Infinera’s cutting edge expertise in Photonic Integration enables cost effective OEO
conversions at a fraction of the expense of traditional OEOs and digital management
of the optical network. By embracing rather than running away from OEO
conversions, Infinera’s system is far more flexible than traditional systems when it
comes to add/drops and customer circuit provisioning, and simplifies managing
bandwidth, monitoring performance, and eliminating noise and optical impairments.
We believe Level (3) and XO have chosen Infinera for national overlay networks
based more on the OPEX savings than the immediate need for additional capacity in
their networks.
A Note On The Potential Impact To JDSU From Continued SuccessAt Infinera.
Infinera is a customer of JDSU but the JDSU optical components content of their systems is
meaningfully less than that of the traditional systems players due to the fact that Infinera
makes its own PIC via its own optical integration technology. As Infinera gains share from
other optical systems players, this could have a slight impact on JDSU’s demand. However,
we note that JDSU itself is a leader in optical integration and is using these capabilities to
maintain 60+% market share in high-value, high-growth intelligent and agile subsystems like
ROADMs, Tunable transceivers, and Agile EDFAs. While these markets represent only
about $100 million of global TAM today they are expected to grow at about 45% CAGR
over the next several years and we expect JDSU to continue to dominate these markets. We
also note that ROADM technology is primarily related to Metro DWDM systems and since
Infinera is a LH player, it should have little or no impact on demand for ROADM subsystems
from JDSU’s optical system customers. The bottom line is that we think Infinera
represents much more of a risk to systems players like Ciena than to components vendors
like JDSU.
VALUATION AND RISKS
CIENA (CIEN–$5.23; 2S)
Valuation
Our price target for Ciena stands at $4.00 and is based on a target EV/CY 06 sales multiple
of 3.3x. This target multiple represents the mean average trading multiple of the service
provider equipment sector under our coverage (range is currently 1.2x-9.1x). While we still
have concerns about the business model and potential continued cash burn, they are now
somewhat lessened by signals that there is a recovery in Optical that Ciena is poised to
benefit from and our belief that the new COO will eventually help the company address the
OPEX issues. For these reasons, we are targeting Ciena at a multiple inline with the group
trading average, which results in our price target of $4 per share.
Our 10-year DCF model, which assumes a beta of 1.8, aWACC of 9.6%, and a 2% terminal
growth rate yields a target price of roughly $2.50, which is up from $2.10 following our
latest model changes, and particularly our GMs estimate increases. For a company like
Ciena, which tends to be momentum oriented, we prefer using peer group multiple analysis
to DCF analysis and are relying on the peer group multiple analysis to set our price target.
Risks
We consider CIENA to be Speculative risk because it is a high beta technology stock that
has historically demonstrated an extremely high level of price, revenue, and earnings
volatility. In addition, CIENA is a small player that competes against much larger
competitors such as Lucent, Nortel, and Cisco. Finally, CIENA operates in the market for
optical equipment, which is a highly competitive market subject to rapid change in terms of
technology, new competitors, and rapidly falling price/performance capabilities.
Risks that could cause the stock to fall below our target price include the following: weak
demand from wireline telecom service providers, a reliance on optical systems sales, order
lumpiness for optical systems, and CIENA’s high cost structure. Order patterns of optical
systems are typically lumpy, large in nature, and can materially impact the results from
individual quarters. We believe CIENA’s cost structure is not in line with its revenue. The
company has been slow to undertake the massive restructuring initiatives that its competitors
have taken in an effort to preserve its competitiveness. As a result of its low gross margins
and high operating costs in relation to sales, Ciena has been burning significant amounts of
cash and liquidity remains a key risk.
Conversely, factors that may cause the stock to materially exceed our target price include a
rebound in overall demand for optical systems, big lumpy purchases from BT, DISA, MCI or
another significant customer, additional large customer wins, or the announcement of further
major restructuring efforts including a focusing down of the product portfolio.
We recognize that the Expected Total Return (ETR) for these shares does not conform to our
ratings grid as configured under our current ratings system. We are currently examining the
likely impact of potential M&A activity in the telecom equipment space as well as the nearterm
gross margin outlook for Ciena as we evaluate how to address this discrepancy. We
view the upcoming outcome of the merger talks between Alcatel and Lucent as a key catalyst
point in this analysis. |
