Telecom & Networking Equipment: Optical Sending Mixed Signals
7 Dec 2018 – Optical coverage been particularly volatile lately as 3D and China data points/tone have skewed bearish. Positively inclined on LITE given sell-off and OCLR acq closure, more cautious on systems vendors given upcoming competition in the datacomm market, highlighted in our updated Optical Scorecard.
Cautious on being too negative around near term componentry opportunity in China, even against an increasingly negative backdrop. Given we take a shorter term view of the optical space, we are more positively inclined on componentry in the near term, particularly if sell-off around Huawei news continues (see Exhibit 1 for our most recent Optical Scorecard). China is an upwards of 20-40% customer or most optical componentry companies (see Exhibit 3), with significant growth opportunities in the near term (e.g. ROADMs), but a more cautious medium / long term outlook as China looks to move away from US based suppliers. This move away from US based component providers was expected to be accelerated given the ZTE ban earlier in the year and could be even more accelerated given the Huawei news this week. Counter to the bearish trade tone around China, the LITE / OCLR deal was approved by China officials Thursday, a move that had not been expected until the trade environment improved. Additionally, as noted in our NASDAQ wrap-up note, IIVI struck a positive tone on the opportunity in China and FNSR reported strength in WSS sales Monday. As a result, we would be cautious being too negative China exposures in the near term, even if a dislocation takes place with Huawei purchasing, as the country is putting into place meaningful 5G infrastructure which requires optical backhaul in the next few years and there are not insourced alternatives yet.
M&A activity ultimately makes us more positive in long term optical prospects, but likely to be messy in short term. We have been vocal around what we see as the need for more M&A in optical, as there are too many competitors with not enough buyers. With three significant acquisitions announced this year (only 2 closed), but with those acquirors stocks down on average about 35% since deal announcement, the obvious question is, what isn’t working? In general, in 2018, we are only seeing the complications of M&A without seeing the gradual profitability improvement that we believe can take place in the industry from fewer suppliers. While we don’t see performance of acquirors improving significantly throughout the remainder of 2018, we think exiting 2019, all three companies (LITE / IIVI / INFN) could be in better condition (if IIVI/FNSR also approved). Reason being, synergy realization will be well on its way, revenue dissynergies will likely be known and joint negotiations can start to take place with customers/suppliers. We believe we are still years away from multiple expansion as a result of consolidation (accretion to come primarily from earnings uplift), but in the case of CIEN, we are starting to see signs of investors being willing to pay more for a sector if volatility has seemingly been reduced (CIEN valuation currently stands at 18x CY19e EPS, 15x cash tax P/E, higher than traditional average around 13x).
While tend to think componentry may be oversold in the near term, think systems valuations may be too high given upcoming competition in datacomm systems. Systems vendor (CIEN, INFN, ACIA – b/c of DSP) valuations are hovering between 15-20x normalized P/E currently, above traditional optical averages. Heading into 2019, because of decelerating hyperscale capex spend (see Exhibit 4) and increasing competition, we think there could be more Q/Q volatility in spend at the beginning of CY19, making us most cautious around systems vendors. This volatility is more likely to play out in Q1 results, when ACIA / INFN will both have new products on the market, potentially taking some of the strength from CIEN’s WaveServer business.
Expectation reset into the quarter biggest reason to not be more negative heading into FQ4 results next week. CIEN reports earnings BMO Thursday, December 13th. Overall, as we move into CY19 and through the year, we think there will be more chance of weakness from datacomm and telco markets for systems vendors like CIEN, given competition and need for limited service provider capex dollars to switch to wireless spend. However, we are not more negative into the quarter as we think FQ4 sets up well given new datacomm competition hasn’t yet been on the market. Consensus currently assumes 5.5% growth in FY19, which, as Exhibit 7 indicates, requires DCI to be a double digit growth business despite increasing competition and slowing cloud capex growth. Our caution around elevated expectations for the FY19 guide (Oct FYE) was the reason for us moving to EW in September. However, while we think it is more likely that CIEN gives themselves some room in their guide, a small revision downwards is likely built into valuation at this point given the number of other sell-siders raising caution heading into the report. We could prove to be too conservative and be surprised to the upside if new deals won in FY18 start to contribute more meaningfully in early FY19, helping non-DCI growth rates, or if investor expectations are so low that in-line is enough to revert upwards.
Continue to be cautious around earnings power of ACIA, but new product release in 1H’19 and elevated M&A activity keep us on the sidelines. As noted previously, we think the consistent earnings power of ACIA is closer to $2 than the $2.5 – $3 currently built into the market. However, with a market leading AC1200 on the market in the 1H, hype around 400ZR still at elevated levels and strategic activity increasingly happening in the space, we are cautious around being negative.
Our $32 price target is ~14x CY19e cash-tax adjusted EPS, which is appropriate given slightly better than typical theme exposures and growth profile.
Key risks to our PT remain a slowdown in macro that could affect service provider spending or the entry of new more competitive products by competitors in 2019.
Our $55 PT is 14x Pro Forma Base Case P/E (ex-cash), or the equivalent of ~12x Base Case P/E (Including OCLR). This is less than our previous multiple of ~15x (ex-cash) as outsized impact of Apple as a customer introduced increased volatility to results. This is a slight premium to historical average of 13x, given more attractive qualitative rating on our optical scorecard.
Key risks include integration complications, poor pricing or poor market share in the 3D sensing opportunity, and changes to China import/export policies.
Our $30 price target is 18-19x normalized EPS ($1.6-1.7) a discount to high growth semiconductor comparables (20-24x) given higher levels of customer concentration.
Key risks include a large customer pulling back purchases or pressuring margins, consolidation amongst customers, large competitor entry into the market.
Our $6 PT is 13x a 2021e EPS of $0.40 – $0.60, discounted back one year. The 13x multiple is in line with the average for the optical universe, for while qualitative exposures would imply a premium, the risk and profitability challenges of the company in the near term cause us to apply a discount.
Risks to our PT are that legacy Coriant products fall off faster than expected, pauses in spending spell longer term share loss, synergy realization remains a challenge, customer loss, and/or product development roadmaps are delayed.