Wednesday, September 06, 2006

Ciena's Reverse Stock Split--Appealing to Short-Sellers?

Last week, telecom-equipment provider Ciena (CIEN-$4.01) announced a one-for-seven reverse stock split. According to the Board of Directors, the purposes of the reverse split were to increase (proportionately) the per share trading price of Ciena’s Common Stock, thereby appealing to a broader range of investors (like institutional investors that are unwilling to invest, and in some cases, have internal policies prohibiting them from investing in lower priced stocks); and to provide investors with more meaningful information of operational results, particularly related to period-to-period comparisons of per share earnings (Ed. note. enhance EPS visibility).

The 10Q Detective took a look at companies that have engineered reverse splits in the last eighteen months, and found that the intent of most splits—despite some exceptions—were engineered to (i) broaden the investor base; (ii) help the company regain compliance with Nasdaq’s $1.00 minimum bid price listing requirement; and, (iii) enhance EPS visibility (by reducing the aggregate common stock issued and outstanding on an as is conversion basis).

Despite some exceptions, the legitimacy of these reverse splits seemed disingenuous at best. These splits did nothing to reverse the ugly stock price trends at the reviewed companies (due to erratic quarterly financial performance). Identified trend reversals ran parallel with underlying improvements in financial health.


Chipmaker Agere Systems (AGR), telecom-equipment provider Oplink Communications (OPLK), sales & marketing provider Rainmaker Services (RMKR), and network services software provider Internap (IIP), which showed share gains of 20.3%, 63.4%, 127.4%, and 21.2%, respectively, also reported material turnarounds in operating profitability.

Ciena’s products allow network operators such as phone companies to handle more traffic at lower costs. Last Thursday, the Company reported for the three months ended July 31, 2006, a net loss of $4.3 million, or a penny per share, down from its year-ago loss of $51 million, or 9 cents a share.

Revenue rose 38% to $152.5 million from $110.5 million.

On an adjusted basis, Ciena had been expected to earn a penny a share on revenue of $143 million, according to the consensus of analysts surveyed by Thomson First Call.

As sales are on an upswing, management believes that by affecting a reverse stock split [the price of Ciena’s store price will increase seven-fold to approximately $28.00 per share], the higher trading price of its Common Stock will be viewed more favorably by potential investors.

A 1:7 reverse stock split would lead to a corresponding reduction in Ciena’s 980 million shares of authorized common stock and approximately 589.3 million shares outstanding to 140 million shares and 84.2 million shares, respectively.

A reverse stock split is no more than a bookkeeping entry. Ciena’s cosmetic ruse cannot hide fundamental weakness’ endemic to the Company. For the nine-months ended July 31, 2006, Free Cash Flow was a loss of $77.6 million. Going forward there are serious concerns as to management’s ability to lower the firm’s relative cost structure enough for the Company to be competitive (and profitable) in its networking space.

Albeit 4Q:06 revenue should grow sequentially 5%, corporate has guided EPS lower, citing lower than previously expected gross margins and higher operating expenses. The current consensus calls for share-net estimate of $0.01 on revenue of $160 million (not adjusted for pending reverse stock split).

Gross margin was 47.0% in the third quarter of fiscal 2006 and 45.8% for the first nine months of fiscal 2006. Gross margin during the third quarter of fiscal 2006 remained strong, primarily due to sales of higher margin channel line cards for Ciena’s core transport systems.

Management cautions, however, that its gross margin remains susceptible to fluctuation from period to period as a result of product mix, competitive pressure on pricing and other factors. In recent quarters, the Company cautions, “it has witnessed a growing interest among telecommunications service providers in building more economical, next-generation core and metro transport networks.” In other words, costing advantages (from larger, incumbent companies and low-cost networking equipment producers in China), coupled with the increasing purchasing power of larger customers (due to increased revenue concentration caused by recent mergers among telecommunications carriers) will pressure gross margins going forward.

During the third quarter of fiscal 2006, three repeat customers represented 51.6% of revenue, and for the first nine months of fiscal 2006, these three customers accounted for 40.4% of revenue.

To reduce operating expenses, management is embracing product convergence and functionality crossover. This strategy calls for the reorganization of prior operating segments and the consolidation of multiple technologies and functionalities on a single platform. In an effort to address this convergence and improve operational efficiency, management has eliminated former business units and no longer has operating segment general managers. As a consequence, Ciena has eliminated the Transport and Switching Group (TSG), Data Networking Group (DNG), Broadband Access Group (BBG) and Global Network Services (GNS) operating segments and will report results as a single business segment.

For the nine-months ended July 31, 2006, operating expenses (OpEx) improved 315 basis points to 54.5% of total revenue (year-over-year), due to reductions in R&D and the amortization of intangible assets costs (offset by a 30.7% increase in year-over-year sales).

New product initiatives and rising G&A expenses will test management’s commitment to execution in the coming quarters.

On a trailing twelve-month basis, Ciena’s return on capital is (5.1)% with a cost of capital of 11.4 percent. Given management’s ineffective use of shareholder capital, the 10Q Detective fails to see how “raising the trading price of the Common Stock will be viewed more favorably by potential investors?”

If anything, at a new share price of $28.00, the stock of Ciena will probably be viewed more favorably by short-sellers.

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