The Zacks Communication - Components industry appears well poised to gain from fading supply chain adversities, increased fiber densification and a faster pace of 5G deployment. However, large-scale investments for infrastructure upgrades to support the transition to 5G, high inflationary pressures and elevated inventory levels amid a challenging macroeconomic environment and uncertain market conditions have led to intense volatility in raw material prices.

Nevertheless, Arista Networks, Inc. (ANET Quick QuoteANET - Free Report) , Harmonic Inc. (HLIT Quick QuoteHLIT - Free Report) and TESSCO Technologies Incorporated might benefit in the long run as pent-up demand for scalable infrastructure rises for seamless connectivity with the wide proliferation of IoT.

Industry Description

The Zacks Communication - Components industry primarily comprises companies that provide diverse telecom products and services to develop scalable network architecture, demand-driven video solutions and broadband access equipment. These include various building blocks such as small cells, routers and antennas incorporated into equipment and facilities and subsequently utilized by service providers to build networks for end users. The product portfolio encompasses optical and copper connectivity products, hybrid fiber-coaxial equipment, edge routers, metro Wi-Fi, storage and distribution equipment for cable TV operators, modems, EMTAs (Embedded Multimedia Terminal Adapter), gateways, set-top boxes, analog and digital microphones, audio processors, glass substrates for LCD TVs and notebooks, ceramic substrates for mobile and laboratory filtration products.

What's Shaping the Future of the Communication Components Industry

Evolution to Demand-Driven Business Model: Fiber networks are essential for the growing deployment of small cells that bring the network closer to the user and supplement macro networks to provide extensive coverage. Telecom service providers are increasingly leaning toward fiber optic cable to meet the burgeoning demand for cloud-based business data and video-streaming services by individuals. Moreover, the fiber-optic cable network is vital for backhaul and last-mile local loop, which are required by wireless service providers to deploy the 5G network. Higher utilization of advanced routers to deliver data packets from one network to another is gaining prominence, while state-of-the-art antenna systems remain essential architectural components for seamless connectivity. Telecom firms are aiding their customers to move away from an economy-of-scale network operating model to demand-driven operations by offering easy programmability and flexible automation. The convergence of network technologies requires considerable investments from traditional carriers (telecom and cable) and cloud service providers. Although these investments will eventually help minimize service delivery costs to support broadband competition and wireless densification, short-term profitability has largely been compromised.

Rising Demand for Scalable Infrastructure: Consumer demand for faster Internet speeds with more capacity continues to grow at an escalating rate, primarily driven by the increasing consumption of videos. The vast proliferation of cloud networking solutions is further resulting in increased storage and computing on a virtual plane. As consumers and enterprises use the network, there is tremendous demand for quality networking equipment. Moreover, the demand for faster data transfer is fueling the growth of optical networks. The industry participants provide the technology that enables customers to manage this exponential bandwidth development cost-effectively through steady investments in state-of-the-art technologies. These include DOCSIS (Data Over Cable Service Interface Specification), DSL (Digital Subscriber Line) and Next Generation PON (Passive Optical Network) platforms that enable service providers to deliver the highest bandwidth to subscribers across any physical connection. Further, some firms offer a variety of pathways for providing services through a combination of network-based video transcoding, packaging, storage and compression technologies required to deliver new IP video formats and home gateways to connected devices inside and outside the home.

Short-Term Profitability at Stake: The exponential growth of mobile broadband traffic and home Internet solutions have resulted in a massive demand for advanced networking architecture, forcing service providers to spend more on routers and switches as carriers aim to upgrade their networks. Further, there is a continuous need for network tuning and optimization to maintain superior performance standards, creating demand for state-of-the-art wireless products and services. Although higher infrastructure investments will eventually help minimize service delivery costs to support broadband competition and wireless densification, short-term profitability has largely been compromised. Margins are likely to be affected by the high cost of first-generation 5G products, profitability challenges in China, the Russian invasion of Ukraine and pricing pressures. Uncertainty regarding chip shortage and supply-chain disruptions leading to a dearth of essential fiber materials, shipping delays and scarcity of other raw materials are likely to affect the expansion and rollout of new broadband networks. Extended lead times for basic components are also likely to affect the delivery schedule and increase production costs. High technological obsolescence of most products has escalated operating costs with steady investments in R&D. High customer inventory levels remain another headwind for the companies.

Zacks Industry Rank Indicates Bullish Trends

The Zacks Communication - Components industry is housed within the broader Zacks Computer and Technology sector. It carries a Zacks Industry Rank #106, which places it among the top 42% of more than 250 Zacks industries.

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates solid prospects. Our research shows that the top 50% of the Zacks-ranked industries outperform the bottom 50% by a factor of more than 2 to 1. The industry’s positioning in the top 50% of the Zacks-ranked industries is a result of a positive earnings outlook for the constituent companies in aggregate.

Before we present a few communication component stocks that are well-positioned to outperform the market based on a strong earnings outlook, let’s take a look at the industry’s recent stock market performance and valuation picture.

Industry Lags S&P 500, Outperforms Sector

The Zacks Communication - Infrastructure industry has lagged the S&P 500 composite but outperformed the broader Zacks Computer and Technology sector over the past year.

The industry has lost 9.7% over this period compared with the S&P 500 and sector’s decline of 9.1% and 16.5%, respectively.

One-Year Price Performance

Industry's Current Valuation

On the basis of the trailing 12-month price-to-book (P/B), the industry is currently trading at 3.41X compared with the S&P 500’s 5.77X. It is also below the sector’s trailing-12-month P/B ratio of 5.29X.

Over the past five years, the industry has traded as high as 4.31X, as low as 1.99X and at the median of 3.09X, as the chart below shows.

Trailing 12-Month price-to-book (P/B) Ratio

3 Communication Components Stocks to Keep a Close Eye on

Arista: Santa Clara, CA-based Arista provides cloud networking solutions for data centers and cloud computing environments. It offers one of the broadest product lines of datacenter and campus 1/2.5/5/10/25/40/50/100/400 Gigabit Ethernet switches and routers in the industry. The stock has gained 64.9% in the past two years. The Zacks Consensus Estimate for the current and next fiscal earnings has been revised 20.6% and 23.8% upward, respectively, over the past year. It has a long-term earnings growth expectation of 17.5% and delivered an earnings surprise of 12.7%, on average, in the trailing four quarters.

Arista continues benefiting from the expanding cloud networking market, driven by strong demand for scalable infrastructure. In addition to high capacity and easy availability, its cloud networking solutions promise predictable performance and programmability that enable integration with third-party applications for network management, automation and orchestration. The company’s product portfolio facilitates the implementation of high-performance, highly scalable and appropriate solutions for every environment. Arista currently carries a Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Price and Consensus: ANET

Harmonic: Headquartered in San Jose, CA, Harmonic provides video delivery software, products, system solutions and services worldwide. With more than three decades of experience, it has revolutionized cable access networking via the industry's first virtualized cable access solution, enabling cable operators to more flexibly deploy gigabit Internet service to consumers' homes and mobile devices.

Harmonic, carrying a Zacks Rank #3 (Hold), delivered an earnings surprise of 55.3%, on average, in the trailing four quarters. The stock has gained 57.3% over the past year. It has a VGM Score of B. Earnings estimates for Harmonic for the current year have moved up 48.4% since February 2022.

Price and Consensus: HLIT

TESSCO: Headquartered in Hunt Valley, MD, TESSCO offers base station infrastructure products, including base station antennas, cable and transmission lines, and network systems products, such as fixed and mobile broadband radio equipment and security and surveillance products. It offers products to the industry’s top manufacturers in mobile communications, Wi-Fi, wireless backhaul and related products. With more than three decades of experience, it delivers complete end-to-end solutions to the wireless industry. The Zacks Consensus Estimate for the current-year earnings of this Zacks Rank #3 stock has moved up 38.2% over the past year.

With the completion of the sale of the retail business, the company is likely to be better focused and more growth-oriented, even as the industry grapples with various supply constraints. TESSCO has multiple growth drivers over the next several years and is poised to benefit from the faster rollout of 5G and the increasing prevalence of IoT. Focus on pricing, stringent cost-cutting initiatives and an emphasis on high-margin products are additional tailwinds.

Price and Consensus: TESS