Ciena believes diversification will lead to growth

As previously reported, the revelation of an unanticipated loss in its fiscal fourth quarter originally sent Ciena's (NYSE:CIEN) shares tumbling yesterday morning. But company management turned those initial losses into a 6.96% gain for the day by describing how Ciena's diversification strategy would enable it to grow revenues faster than the overall market and improve margins in 2015. The diversification includes the markets Ciena serves and its product line.

As previously reported, the revelation of an unanticipated loss in its fiscal fourth quarter originally sent Ciena's (NYSE:CIEN) shares tumbling yesterday morning. But company management turned those initial losses into a 6.96% gain for the day by describing how Ciena's diversification strategy would enable it to grow revenues faster than the overall market and improve margins in 2015. The diversification includes the markets Ciena serves and its product line.

On the market side, President and CEO Gary Smith and Senior Vice President, Finance and CFO James Moylan Jr. focused during the company’s analyst call Thursday morning on how Ciena had positioned itself to successfully work what they described as the two ends of the new cloud-based, on-demand communications environment. On the one end is the "content to user" connection, dominated by Tier 1 carriers such as existing customers Verizon and AT&T. The other end features "content to content" connections among what the executives repeatedly referred to as "Webscale" companies such as Amazon, Facebook, and Google, along with colocation and interconnect services providers such as Equinix.

Since the Webscale companies lease communications services from the traditional service providers, technology vendors must sell to both groups to fully engage the new communications market, the executives asserted. Ciena's relationships with mainstream providers such as AT&T and Verizon are well known, albeit a source of concern among financial analysts as those companies signal flat to reduced capex for next year. Smith and Moylan therefore spent much of their presentations underlining the company's success with Webscale companies.

Smith touted an as-yet unreleased report from market research firm Ovum that he said would peg Ciena as the leader in global market share of sales to Internet content providers and carrier-neutral service providers. To back this up, Smith revealed during the call's question and answer session that the second largest customer by revenue for the fiscal fourth quarter was a Webscale company. He added that about a third of the 100-Gbps ports deployed in the quarter went to such customers.

Smith estimated direct sales to Webscale companies currently represent about 5% to 10% of Ciena's revenues; Moylan later said the segment represented less than 10% of sales, but is the company's fastest growing vertical.

In comparison, sales to Verizon and AT&T are expected to continue to shrink as a percentage of overall sales, according to Moylan. He said that the two customers had combined to account for 29% of Ciena's revenues in 2013 and 26% in 2014. Moylan positioned the further decline in 2015 as a result of successful diversification rather than revenue reduction. Moylan carefully avoided predicting how sales from the two giants might change in 2015, although he indicated the fact that AT&T had just named Ciena as one of the carrier's Domain 2.0 technology suppliers should be considered a positive sign.

Ciena's management plans to further this market diversification by beefing up the company's activities in the cable MSO, government, research and education, and other non-telco domains. Revenues from MSOs grew 34% in fiscal 2014, Smith said, while non-telco customers accounted for slightly more than 30% of revenue in the fiscal fourth quarter. About half of the fourth quarter's 100-Gbps port shipments went to non-traditional telco customers, Moylan added.

Meanwhile, the company's new products should help with diversification as well, in this case adding software-enabled service creation and delivery products to Ciena’s hardware offerings. While the recently announced 8700 PacketWave packet switch was described as relevant to both metro and data center networking, the company's efforts in software-defined networking (SDN) and network functions virtualization (NFV) under its OPn initiative are highlights here, Smith and Moylan said. Products such as the new Agility Matrix NFV delivery platform should play well in the new cloud-centric environment, the executives predicted.

The offerings also should help with gross margin, they added.

Thanks to the diversification of both Ciena's customer base and product portfolio, Moylan made the case that the company will see 7% to 9% revenue growth in 2015, despite the expected percentage decline in Verizon's and AT&T's contribution to sales. Moylan pointed out that this growth rate exceeds forecasts of 5% to 7% for the market overall.

The greater percentage of high-margin product sales (coupled with the fact that Ciena was no longer offering AT&T price discounts as an inducement to earn a spot on the Domain 2.0 roster) also should boost gross margins for the year into the low-to-mid 40% range on a consistent basis, Moylan asserted. The company should achieve adjusted operating margins for fiscal 2015 of 8% to 9% he added. This would be an improvement over the 6.5% enjoyed in fiscal 2014.

Wall Street analysts generally liked what they heard. "After a cloudy year, Ciena has shined a rather bright light on the road ahead," wrote Dan Gallagher in the Wall Street Journal.

"The aggressive build out of cloud services by companies such as Google and Microsoft helps boost demand for Ciena's gear. And this type of expansion shows no signs of cooling in the year ahead. Ciena was trading around 15 times forward earnings before Thursday's report, a discount to peers at 18 times on average, according to FactSet," Gallagher added. "Given that, Ciena's stock should have sunnier days ahead."

"We believe increasing spending on optical upgrades and higher number of orders from international customers will boost Ciena's top line in fiscal 2015 and beyond. Moreover, the company's Tier 1 contract wins and strong backlog are expected to boost near-term results," wrote Zaks Equity Research. "Additionally, the diversification of customer base and expansion of the addressable market will be a major growth driver going forward."

Even more cautious commentators took note of the potential benefits of Ciena's diversification. "We think management has set a high bar for the year, considering the challenges in the service provider market and its top tier carrier customers," wrote Simon Leopold of Raymond James in an investor note. Leopold maintained his Market Perform rating on Ciena's stock. "Improved customer diversification and the addition of Webscale customers helps, but we see the risk of quarterly lumpiness as high, and combined with ongoing margin challenges, we would remain on the sidelines on the stock."

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