Ciena blames 'unreliable' suppliers as profits tumble

Under US fire, China's Huawei once likened itself to a plane riddled with bullets whose only mission was to remain airborne. If US-based Ciena – which competes against Huawei in the optical equipment sector – were also imagined as an aircraft, it would be one that is gliding on fumes, its pilots hoping for an aerial refuelling before it drops any further. A shortage of the components it needs to make its products is turning into a mini crisis for the company, as the latest figures show.

After rising 14% for the second quarter (ending in April), sales lost altitude during the third, falling 12% year-on-year to about $868 million. The appetite for Ciena's wares is not the problem, CEO Gary Smith has insisted. "Despite continued strong customer demand, our fiscal third quarter financial results were negatively impacted by late delivery and substantially lower-than-committed volume from a small number of suppliers for specific components that are essential for delivering finished goods to our customers," he said in prepared remarks.

Figure 1: Ciena's share price ($) (Source: Google Finance)

Ciena appears to have been let down by a handful of unnamed suppliers outside China (Mike Genovese of Rosenblatt Securities believes one culprit is Texas Instruments) that make low-cost integrated circuits. While they represent only a small fraction of total materials, their failure to meet earlier commitments hurt Ciena's ability to produce modems that go into its optical equipment, Smith told analysts on the company's earnings call. "But for this specific challenge we would have been at the high end of the revenue range," he said. Ciena had previously guided for third-quarter sales of between $870 million and $930 million.

The knock-on effect of the sales drop will be stomach-lurching for even the most resilient investor. Ciena's gross profit fell 28%, to around $347 million, while its operating income was down 61%, to less than $74 million. Those reductions left it with a third-quarter gross margin of just 40%, 8.5 percentage points less than it managed for the previous quarter. Its operating margin has shrunk from 19.1% to 8.5% over the same period. Ciena's share price was down 10% today at the time of writing.

Bad optics

Margins were squeezed hard for a few reasons. For one thing, the shortages affected the converged packet optical business where Ciena generates the bulk of its profits (its smaller routing and switching division continued to perform strongly, with revenues up 44.5%, to $100.7 million). Efforts to mitigate the crunch, such as a hunt for alternatives (including brokers of used parts), drove up costs.

Ciena also continued to recruit staff, hiring another 477 employees during the quarter to finish with 8,013 in total. Quizzed on that move, Jim Moylan, Ciena's chief financial officer, insisted it was in line with plans announced at the start of the year as it expands its product portfolio in routing and switching. "We have to bring people into R&D and the salesforce. That is why the headcount has grown. It is not going to grow at that level next year."

Even so, the company now seems likely to miss the full-year guidance it previously issued, including the forecast that its gross margin would end up between 43% and 46%. For the first nine months of the year, that figure works out at just 42.3%. There was no mention of any changes to outlook in the financial documents Ciena published earlier today. But as well as missing its own third-quarter sales target, it is guiding for revenues of just $800 million to $880 million this quarter – down sharply from the $1.04 billion it made a year earlier.

Nor is Ciena expecting any kind of supply chain improvement this year. While most of its suppliers appear to be over the worst of the pain, finding alternatives to the handful that Moylan described as "quite unreliable" could necessitate product redesigns. Another risk is of ongoing Chinese factory lockdowns. Although the component suppliers in question are not Chinese, it is possible they use subcomponents from China, acknowledged Scott McFeely, Ciena's senior vice president of global products and services.

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The news is not entirely bad, though. Ciena continues to be highly regarded by the analyst community for the quality of its optical equipment, and its order backlog has now grown to about $4.4 billion, up from $3 billion in March. It is sought out as an alternative to Huawei, claimed Smith, and growing its market share as operators and Internet companies add capacity to cope with soaring usage of data services.

The main danger, perhaps, is that customers waiting on Ciena begin scouting for alternative vendors to satisfy demand. "We have not seen cancellations," said Smith. "They understand the challenges we are having, but because of our technology and relationships we believe that when the smoke clears from all this we will gain share given the outsized demand we see."

Analysts are not unsympathetic. Dave Kang at B Riley Securities said he remains "constructive" about Ciena in a research note issued shortly after the company's earnings call. "We believe the supply chain situation, which is mainly impacted by a handful of bad suppliers, will eventually improve, as the company is trying to mitigate the situation, including redesign of hardware and re-qualifications of suppliers," he said. Shareholders must hope their patience is soon rewarded.

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— Iain Morris, International Editor, Light Reading