Few bright spots in a topsy-turvy year

BY KEVIN SLOCUM and ROBERT MANDRA

The final months of 2000 and thus far the first few months of 2001 have proved to be one of the more humbling episodes for communications and technology analysts in the past 20 years. We took last month off from the column in hopes of having a clearer head when we sat down to write this month's piece. We are not certain it did the trick, but you must get back on the bike at some point.

Right now, Wit SoundView's communications coverage includes 17 companies that we consider having optical communications technology as an important component to their story. Of those companies, six have less than two years of public company history. For the remaining 11 companies that have been public for that amount of time or more, the median share price has fallen back to April 1999 levels and the average was back to January 1999 prices.

It is a little hard to fathom, since that really puts you back at the point where investors began to recognize the importance of optical technology to communications in the first place. The fall has taken stocks in the group from stratospheric multiples of earnings to where they have more recently been trading at substantial discounts to expected growth. Almost everyone will respond to that claim by saying, yes, but you can't trust the estimates that support that statement, as evidenced by the constant downward revisions of expectations since last fall.

We can't argue with that, but the same standard was not present on the upside. The trees were going to grow to the sky and no one had an issue with that. The pendulum seems now to have swung as recklessly in the downward direction. Investors can't seem to imagine how things will ever look healthy again. Their focus can't seem to shift out to a point in the future beyond the current inventory correction, when growth should return, albeit at more sustainable levels. We are uncertain just what will cause that shift in focus, but we are convinced it will happen.

When it does, we believe there will be some dramatic changes in the perception of where certain companies' share prices should be trading. The last downturn we went through created great buying opportunities throughout the optical sector. That was the Asia liquidity crisis in the fall of 1998. The speed with which the current industry slide took hold has surprised everyone. Despite that, all are predicting an elongated bottom. Given that things have come to such a grinding halt, we have a hard time understanding that view.

From what we hear, bandwidth demand has continued to grow robustly during the past few quarters. No one we speak with believes that will change in a meaningful way. Much of the incremental supply that was being brought onto the market, whether you're talking about components, systems, or carrier networks, has been dramatically curtailed. That should sow the seeds of a shape turn. Who predicted the sharp decline we have encountered? Can the predictions of a long stay on the bottom be accurate, or are we setting up a sharp rally in the sector that leaves us chasing our tails again?

We pulled our horns in here and there as things began to slide, but that is probably like saying we hit the wall at 60 miles an hour instead of 90. With that warning, we think that it is time to hedge those bets that say the optical communications market is dead for a while. Where do you start? Lower earnings guidance continues to pound stocks still lower that you thought were cheap. There is only one company that we follow that seems to be able to say that it feels as good about its outlook today as it did six months ago. That is Ciena.

Most analysts seem to view Ciena as the best of a bad lot. The average rating today is a buy. Consensus EPS estimates for the company's October 2001 and 2002 fiscal year are 73 cents and $1.16, respectively. Our own view is that the company will better those numbers. We are looking for October 2001 EPS of 79 cents and $1.40 for October 2002. If we are right, the company will be pushing the street higher with each quarter it reports in an environment where investors are expecting the opposite.

The stock was trading at about 50 times the current fiscal year consensus EPS estimate. On a forward 12-month basis, it was trading at about 41 times consensus EPS, which was about half the expected revenue growth over that period. If our numbers are correct, Ciena's share was trading at 36 times forward 12 months earnings and only at 45% of expected top line growth. If we ignore the last couple of years, it has not been unusual in the past to see well-situated technology equipment suppliers trade at their forward revenue growth rate times projected earnings. For Ciena, on the consensus numbers that would mean about $60 a share; on Wit SoundView's numbers, the target would be $78. Right about now, we would take either number.

We think Ciena has the potential to be one of the best-performing technology stocks of the next three to five years. The market slide that commenced for Ciena in October 2000 has produced what we believe will prove the best buying opportunity of the next few years. With few exceptions, we have a hard time thinking of a communications company that could have brighter prospects over that time frame than Ciena. We suspect that the company could emerge over the next few years as a leader in the communications field, much like Sun Microsystems and Dell Computer did from the computer industry transformation that occurred during the '80s and '90s.

Look at what is going on around them. Lucent Technologies is in a struggle for its survival, forced to sell some of its most attractive assets to regain its footing. Nortel Networks may not be as destitute, but from a behavioral perspective, the management that has chosen to stick around so far is making statements that suggest a lack of respect for the history of the comings and goings of companies in the technology world. Cisco Systems has seemingly failed to get a grasp on the optical opportunity, all the while it is being challenged in its core markets.

Ciena seems to us like a football running back that broke through a pass-prevent defense and has nothing but the safety and a couple of defensive backs between it and the goal. Its CoreStream platform appears to be hitting the sweet spot of the DWDM market. Its incremental approach to ultra-long-haul DWDM seems to be just the right approach in a market where carriers are taking the economy one day at a time. CoreDirector is spot-on what carriers are looking for in a time of searching for economical solutions to getting more out of existing bandwidth capacity. It's metro success may be something you can question; however, the next few quarters may put an end to the questions.

Even today, Ciena is trading at more than three times the trough it saw in the fall lows of the Asia liquidity crisis. We would not be surprised if the same opportunity lies ahead. For all these reasons, it is the company we would look at first when you start to believe we are heading back up.

Kevin Slocumis a managing director and communications research analyst for Wit SoundView (Stamford, CT). He has more than 18 years of financial industry experience, including equity research, sales, and analysis. He can be reached at (203) 462-7219 or kslocum@witsoundviewcom.

Robert Mandrais a principal in investment banking with Wit SoundView (Stamford, CT). Previously, he was an optical engineer with MIT Lincoln Laboratory for nine years. He can be reached at (203) 462-7361 or at [email protected].