Anticipatory buying will emerge in the optical communications sector late this year, but to trigger a sustained recovery, some meaningful signs of spending will probably be necessary.
BY KEVIN SLOCUM
Our September column in Lightwave ("Time to buy optical again," page 39) rehashed a late June stock call that was ill-timed. We speculated that the June and July quarter reports and predictions about the balance of 2001 would precipitate a bottoming-out for the shares of optical communications companies. In anticipation of that possibility, we upgraded a few stocks in the sector and reiterated favorable recommendations on a few others. The jury was already in on that call before the tragic events of September 11. The call was wrong. The summer dive in the business and the stocks was deeper than we imagined and there was no rebound in sight.
We still believe that the late summer and early fall months represented the crescendo of negative news for the sector; however, with the benefit of hindsight, a delay in suggesting new share purchases until the bulk of the news had hit would have been more appropriate. Since that September column, we felt compelled to fall back on all of the stocks we had upgraded, including JDS Uniphase, Nortel Networks, Optical Communications Products, and Digital Lightwave. These four companies are now rate holds by SoundView.
Our list of strong buys continues to include Ciena, Finisar, and Tellium. We feel especially strong about Ciena and Finisar. For Ciena, we were certainly disappointed about the extent of the fiscal 2002 guidance reduction, but we continue to believe that the company's performance is extraordinary in such a difficult time for the telecommunications industry. That performance is a testament to Ciena's strong product position, execution, and in our view its likely future relative performance.
Finisar is our second-strongest choice. With the company's July first fiscal quarter report, management signaled that it believed it had seen the bottom in its business and that it was hopeful the October quarter report might produce better results than the July period, even though guidance was for a flat performance. A broad-based improvement in orders across most products and numerous new product-design wins were the driving forces behind that renewed optimism.
For Tellium, we harbor some reservations with our rating but have chosen to ride out the storm with the company because of what we expect to be strong demand in the sectors it addresses. Investors have challenged us on our rating. With a short list of customers and two that have documented capital spending constraints, the challenge for the stock is obvious. We have been in touch with its customers and came away comfortable with the near-term prospects. We continue to monitor those relationships, and the word from customers thus far has been that they continue to view their relationship with Tellium as strategic and that spending plans with the company are on track. In addition, Tellium management believes it is on track for a new customer before year-end. We have decided to stick to our guns on our strong buy rating, but because of customer concentration risk, Tellium is our most vulnerable recommendation at this point.
Given the challenges of the sector, it is probably only appropriate for us to focus on this short list of companies until we see clear evidence of a positive turn. The natural question following that point is, when do you think that might emerge? As if things weren't already challenging enough for the sector, the extra drag placed on the economy by the tragic events in New York City and Washington, DC in September probably cemented an even more challenging business climate for the balance of 2002. That leaves the March 2002 quarter as the last very daunting year-over-year quarter for the industry. It is also the slowest seasonal quarter for the industry. From that point forward, the industry's growth comparisons get progressively easier and our bet at this point would be that so will the prospects of the optical communications industry and their shares.
The burden of proof remains on those of us that have continued to express optimism for the future of optical communications, and broadband communications in general. Therefore, while we would expect some anticipatory buying to emerge in the sector late this year, some meaningful signs of a recovery in spending will probably be necessary to trigger a sustained recovery.
We will continue to search for leading indicators by asking the following questions:
- Has the financial community reached a level on estimates that seem to be consistent with near-term financial performance of the companies they monitor?
- Is there an abatement of the insider selling that has been so prevalent throughout the decline in the sector?
- Have inventory levels continued to come in line with the more anemic pace of the industry?
- Are there any strategic buyers that see enough promise in the future to step past the near-term negatives and invest in the sector?
- Do we finally get some business indications from the technology leaders in the field that there is a reversal-of-order fortunes that may be meaningful enough to signal a turn for the better?
The best chance for several of these questions getting an affirmative answer is early next year. There is a possibility with depressed share prices that strategic buyers could show up sooner, but buying on that possibility alone would be a flimsy excuse. So if you don't have the time or interest in guessing or waiting for the bottoming-out and you remain convinced, as we do, that things will improve in the months ahead, we start with Ciena and Finisar and will build the list from there, as the questions we noted are answered more and more in the affirmative.
We sincerely hope Thanksgiving finds you well.Readers pondering the opinions and analysis provided in this column are reminded that any investment involves risk. Lightwave and its parent company, PennWell Corp., are not responsible for the success or failure of investments made as the result of information provided in this column or anywhere else in the magazine.
Kevin Slocum is 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 at kslocum@witsoundviewcom.
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