Ciena Detonates the Market

Sacred cows are always slaughtered last. Ciena gave the equity markets an unwelcome surprise yesterday and triggered a broad market sell off in the sector. This event challenges Ciena’s status as a sector favorite as well as the perception that a video boom will save us all.

Favorite Son

While Infinera, JDSU, Avanex, and Nortel all offered negative guidance in the past months nothing shocked the market quite like Ciena.

On a day where general market indexes lost 3% today, the big cap communication index (GSTI, or iShares IGN) lost nearly 5%, and the Nyquist Small/Mid cap Index lost nearly 6% (the 14th largest decline ever), Ciena declined nearly 25%. Yes, the market was weak, but Ciena’s announcement brought extra punishment to this sector. After reporting $253M in revenue for Q3 Ciena indicated Q4 would be $190-$210M, a 20% quarter over quarter decline.

Ciena is an important sector bellwether. It represents the ‘favorite son’ of the optical sector. Funds wishing to gain exposure to ‘Optical’ turned to Ciena and JDSU in the past years when populating their portfolios. As a result, both stocks tend to disproportionately reflect the sentiments of investors towards this sector. This is exemplified by Ciena’s out performance of peers during the last five years- while lesser known companies struggled Ciena was kept afloat by institutional money flow, and subsequently had a premium valuation.

That all ended yesterday.

Ciena significantly under performed the Nyquist index in the past few weeks, and was not acting well. It broke a critical technical support point in July. We pointed out in our weekly letter that this reversal was a sign that the sector favorites were finally being sold, joining their lesser known peers that were severely punished during 2008. This is a positive sign, as the darling stocks are the last to go in a bear market.

When the sacred cows are led to the slaughter it is an indication that the end of the end is near.

Ciena’s Perspective

Ciena indicated they see a “short-lived albeit multi quarter slowdown,” a statement at odds with itself. Visibility beyond multiple quarters, regardless of what is said, is impossible. Only a year ago (4 quarters) Ciena proffered positive guidance based on healthy capital spending, resulting from a boom in video traffic.

We have argued (see “Internet Traffic Growth Doesn’t Matter”) that this ‘boom’ is a marketing invention of sell-side analysts, politicos, and companies who all conveniently find this premise to be in their self interests. The reports from multiple companies this quarter (AVNX, JDSU, INFN, NT) all fail to support the conclusion, as do quantitative data from carriers, content delivery providers, and independent analysts.

Ciena indicated this slowdown resulted from Tier-1 customers, primarily North American, and it is a poorly kept secret (Ciena refers to them as customer A, B, C etc) that a third of their revenue is from AT&T and Sprint. Our first reaction was that the Coredirector, an older system sold primarily to AT&T, and a perennial gravy train for Ciena, was the source of next quarters weakness.

The revenue from the system must be nearing it’s peak – in fact Ciena long ago shut down the entire site originally responsible for the product (they are now at Infinera). But Ciena was firm that the Coredirector is not the source of weakness when responding to a question.

The Core Director deployments are ongoing and we believe on track for the remainder of the year. We’ve seen ebbs and flows before and we absolutely believe that the Core Director deployments at AT&T are on track and we have some visibility into that.

Coredirector is an $80M/quarter (one-third of revenue) business. This means the remainder  of Ciena’s business is projected to drop from $170M to $120M (-30%) quarter to quarter. If this is the case, the WDM transport business at Ciena has fallen off a cliff.

Either CEO Gary Smith isn’t accurate about Coredirector, or the WDM transport business imploded.

Opinion

We see no indication that Ciena has suffered market share loss. Close observation of peer companies, like Adva and Infinera, shows sector weakness as well. Carrier capital expenditures, excluding China, are well below trend for 2008. When this reverses Ciena’s fortunes will change – so long as the source of weakness is not a permanent decline of Coredirector revenue.

What may not return is the premium valuation bestowed upon Ciena as a sector leader. The belief that a groundswell of transport demand from video also appears to fundamentally shaken.

Guess we all better start watching more YouTube.