We are lowering our price target to $13.00 from our previous $17.00 for Ciena Corp. (CIEN). Although we anticipate a recovery in 2011, Ciena could exhibit high volatility due to the lack of a near-term visibility, integration related risk, increased expenses, continued losses and intensifying competition.
Additionally, we believe that the possibility of a slowdown in carrier capital spending is likely to dampen results in the near term. Our long-term Neutral recommendation, however, remains in place.
Ciena’s most important competitor, Cisco Systems (CSCO), recently launched a carrier routing system called CRS 3 that would enable data transfer speeds of up to 322 terabits per second (tbps), significantly higher than the 92 tbps of CRS-1, which is currently used by many of the major carriers around the world. This could lead to a substantial loss of customers for Ciena, slowing revenue growth.
Risky Nortel Acquisition
The recent acquisition of Nortel Network’s optical networking and carrier Ethernet business – the Metro optical and Ethernet Networks (MEN) division, which includes Nortel’s long-haul optical transport portfolio, when combined with Ciena’s core switching products will drive much higher revenues and ensure increased profitability for the company.
The Nortel acquisition, the largest in ten years for Ciena, would help the company expand in Asia and Europe, provide higher cross-selling opportunity, strengthen competitive position, enhance operating leverage, strengthen product portfolio, broaden customer base and benefit from partnerships with large companies such as International Business Machines Corp. (IBM).
Ciena’s acquisition of Nortel’s MEN business is expected to be significantly accretive to operations in fiscal 2011. After the integration, the company expects to achieve revenue growth of 10% to 12%, gross margin in the low to mid 40% range and an operating margin of 7% to 10%.
However, the Nortel acquisition comes at the expense of high execution and integration risks. Also, the increasing exposure to the volatile European market is expected to offset some of this growth in the near term. Since the Nortel’s MEN business is a lower margin business and comprises a larger proportion of Ciena’s revenues, it will lower the combined company’s margin in future quarters.
Ciena recently raised $375 million in convertible senior notes to help finance the purchase of Nortel’s assets. As a result, long-term debt (convertible notes payable) increased to $1.17 billion in the second quarter of 2010 from $798.0 million in the previous quarter. Standard & Poor’s have lowered its credit rating on Ciena from B+ to B (financial situation varies noticeably).
Currently we would advise investors to remain on sidelines until there is more clarity on Ciena’s successful integration of Nortel.
Second Quarter Highlights
The quarterly loss of 21 cents per share narrowed from a loss of 38 cents per share in the year-ago quarter and beat the Zacks Consensus Estimate of a loss of 36 cents per share.
Total revenue of $253.5 million in the quarter was up 75.6% year over year. This includes $53.5 million (21.1% of total revenue) from the acquired MEN assets of Nortel Networks on March 19, 2010 (or approximately six-weeks of Nortel’s operations).
Third Quarter Guidance
Ciena’s third-quarter 2010 guidance (provided during the second quarter conference call), which is the first full quarter to include the operations of Nortel’s MEN business, was extremely good, beating Wall Street expectations.
Ciena expects third-quarter 2010 revenues (combined company) to be in the range of $375 million to $400 million, ahead of the Wall Street target of $337 million. This is a 52.9% increase from the second quarter.
The company did not provide any earnings per share guidance; however, the current Zacks Consensus Estimate for the third quarter is pegged at a loss of 44 cents versus a year ago period loss of 5 cents. The integration-related costs of approximately $180 million in the first 12 months of closing the Nortel deal are diluting Ciena’s earnings.
Estimate Revision Trend
Ciena’s good guidance given out last quarter is reflected in the analysts’ upward revision of estimates over the past month. Of the 6 analysts covering Ciena, 5 had revised estimates upward for both the third quarter and fiscal 2010, implying that they do see a meaningful catalyst for the time being.
Following the second-quarter earnings release, earnings estimates for the third quarter and fiscal 2010 improved to a loss of 44 cents and $1.07 per share from the previous estimates of a loss of 47 cents and $1.26, respectively.
Despite the increase in analysts’ estimates, year-over-year results remain suppressed due to increased expenses related to integration of Nortel. The current Zacks Consensus Estimate is a loss of $1.07 for 2010, reflecting a year-over-year decline of 46.6% from a loss of 73 cents.
We anticipate a recovery based on the favorable operational execution translating into a gradual improvement in results. However, near-term results are expected to remain under pressure due to increased expenses, volatile European market, slowdown in carrier spending and continued losses.
Ciena currently has a Zacks #3 Rank (Hold) and a longer-term recommendation of Neutral.