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Hard-To-Value Finisar Could Be In For Better Days (FNSR, JDSU, CSCO, CIEN)

Stephen D. Simpson, CFA

It can be dangerous to have a good feeling about a company's stock, but not be able to back it up with strong quantitative data. And yet, that broadly describes most turnaround situations, as the timing and magnitude of earnings and cash flow recoveries are so hard to model accurately. With that in mind, I think Finisar (Nasdaq:FNSR) could be in for better days as upgrade cycles in the data center and telecom markets take revenue and earnings higher.

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The Company in Brief
Finisar is the largest player in the optical components space, holding about a 16% share of the market for products like transmitters, transceivers and transponders that customers like Cisco (Nasdaq:CSCO), IBM (NYSE:IBM) and Ciena (Nasdaq:CIEN) use in their data center and network equipment. As such, Finisar is not only a good play on data traffic growth and the increasing use of optical products in data centers, but also the recovery in carrier spending.

The Push-Pull of Competition
Although Finisar is a little larger than JDS Uniphase (Nasdaq:JDSU) and Oclaro (Nasdaq:OCLR), JDSU has a larger share of the ROADM and tunable XFP markets. New products at Finisar may shift some of that share, though. Finisar's new ROADM line cards sell for as much as two times more than modules, and it looks like the company is breaking into JDSU customers like Cisco and Ciena.

On the other side of the competitive fence, there are threats that Oclaro's merger with Opnext gives the company more operating leverage, and perhaps more opportunity to compete on price. Elsewhere, Cisco's acquisition of Lightwire creates at least the possible risk that Cisco will internally source more of its 100G component needs - a meaningful threat to Finisar given that 100G adoption/rollouts are a big part of the rationale for higher sales and profits in the coming years.

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More Spending at Last?
Analysts and investors have been waiting for some time now to see an increase in carrier spending. While AT&T (NYSE:T) has guided to more capex spending in 2013 (including 100G) and Verizon (NYSE:VZ) too seems to be devoting more resources in that direction, there's an element of "we'll believe it when we see it" to these projections. It's true that carriers eventually have to build out capacity, but finding specificity on the timing and amount has proven to be something like nailing Jell-O to a tree.

On the data center side, Finisar should be looking forward to an upgrade cycle to 10Gbps products. I say "should" because major data center providers have all pointed to a slowing in spending and cautious customers. Here too it is probably a "when, not if" upgrade cycle, but waiting on that "when" can be frustrating for investors and difficult for the stock price.

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How Good Can the Good Times Be?
Finisar's datacom business has held up pretty well even while telecom spending has been soft. Unfortunately, this is a company that has only reported positive operating margins three times in the last 10 fiscal years and positive free cash flow (FCF) three times as well (and not in the same years). Suffice it to say, that makes modeling the margins and FCF in the coming years more of an exercise in guesswork than is typically the case. With the company having also reduced the transparency of its reporting (giving less product/segment detail), this is not an easy model to build and that increases the risk of this stock.

The Bottom Line
If Finisar can post a peak recovery FCF margin in the low teens, fair value on these shares is likely in the mid-teens. Boost that peak into the mid-teens, though, and the fair value climbs into the high teens and the shares look more compelling. Admittedly, this is a lot of guesswork at this point, and it's worth noting that today's EV/revenue multiple of 1.3 times could easily move past 2.0 times (or higher) once the Street is convinced that the recovery is on.

Consequently, while this is a stock with above-average risk and very uncertain fundamental value, I do believe that, as in the case of Ciena, an argument can be made that these shares will outperform if and when that carrier spending recovery materializes.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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