Monday, April 12, 2010

Ciena (NASDAQ:CIEN): Upgraded to Buy at Merrill/BAM, see upside to $40

Merrill Lynch/BAM is upgrading Ciena (NASDAQ:CIEN) to Buy from Underperform with a $22 price target (prev. NA)

Firm notes Ciena has embarked on a transformative acquisition of Nortel’s optical and Metro Ethernet Networking (MEN) assets. MLCO sees the combined entity well-positioned to take advantage of the multi-year capex upcycle in optical networking. With several new product cycles from Ciena (nextgen Core Director, WWP wireless backhaul switches) and Nortel MEN (40G/100G WDM), they think Ciena-Nortel MEN can become a powerhouse in global optical networking with a chance to substantially improve from their current 9% market share in a $16bn global market.

They expect the upcoming April 20 Analyst Day to be a positive catalyst for the stock, with Ciena possibly rolling out a combined financial model for the Ciena and Nortel-MEN assets.

35% upside potential based on $22 PO
MLCO's $22 PO is based on 1.5x 2011E EV to pro-forma sales potential for the combined assets. The choice of 1.5x is within the comparables range of 1x – 3x but at a slight discount to Ciena’s 2.2x, 3-yr median EV/S, which the firm believes captures the Nortel-MEN integration risks and lower future growth rates. But they see substantial additional upside to the stock, should the merger with Nortel be well executed.

MLCO notes that under the assumption of 20x P/E target (inline with historical levels), and $2.06 in earnings power, they think the stock could approach $40 once the growth and profitability targets are achieved.

Positive carrier capex trends in 2010
Since the beginning of this year, almost every US carrier (Ciena’s core market) including AT&T, Verizon, Sprint, Qwest and Level(3) has maintained or raised capex expectations. In some cases, the incremental capex will go towards wireless rather than wireline, but within the wireline segment, MLCO sees substantial focus on optical networking and Ethernet.

The main challenge for carriers now, in their view, is to reduce the cost of operations when traffic growth grows exponentially and revenues decline. The focus is therefore to offload traffic from the expensive IP MPLS infrastructure to the cheaper optical and Ethernet layers.

In MLCO's view Ciena is well positioned in wireless backhaul with its new Ethernet (WWP) portfolio; they also see strength in optical switching and metro optical where capacity demand continue to increase. irm thinks we could also see incremental benefits (in late 2010 onwards) from domestic broadband stimulus programs.

Stock has run but not done
Over the past year Ciena stock has appreciated about 80%. Yet this doesn’t stop MLCO from upgrading the stock. In their view, a successful integration with Nortel, coupled with growth in the underlying market could translate into a substantial earnings upside. The consensus view is still mostly skeptical or even negative, and good financial performance could therefore bring new investors to the stock.

Over the years, Ciena’s stock followed its earnings cycles with investors typically over-shooting or under-shooting at the peak and the bottom of the cycles. It happened in late 2007, when AT&T and Verizon were both buying the high margin Core Directors at the same time, and it may happened again now, given that multitude of pending projects they see in the market.

Notablecalls: With a firm the size and power of Merrill upgrading CIEN, people will take note.

Merrill is also suggesting that if everything goes as planned, CIEN will be a $40 stock, implying well over 100% return.

The stock has responded very well to similar comments (namely, the CSFB upgrade from Jan) and I suspect we may see a similar reaction in the very n-t.

Technically speaking the stock is very close to breaking to fresh 52-week highs, which should contribute to buy interest.

I think CIEN will trade over the $17 level and potentially closer to $17.50 today (the market needs to play ball for CIEN to achieve the higher end of the range, though).

Note there's a 25% short intrest in the name. Explosive combo!

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