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Near-Term Headwinds Mar Communication Components Outlook

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The Zacks Communication - Components industry primarily comprises companies that provide diverse telecom products and services for the development of scalable network architecture, demand-driven video solutions and broadband access equipment. These include various building blocks such as small cells, routers and antennas that are incorporated into equipment and facilities, and are subsequently utilized by service providers to build networks for end users. Their 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, cable and DSL modems, EMTAs (Embedded Multimedia Terminal Adapter), gateways and set-top boxes.

Some firms within the industry also offer cloud networking and virtualization solutions for data centers and cloud computing environments along with end-to-end network visibility and analytics that help build, test, certify, maintain and optimize complex physical and virtual networks. These companies employ multiple silicon architecture to offer highly modular networking solutions. Some industry participants offer innovative audio products, including analog and digital microphones and balanced armature speakers, audio processors, and software and algorithms that are used in applications that serve the mobile, ear and IoT markets. A few industry participants even provide glass substrates that are commonly found in LCD TVs, notebooks and flat-panel desktop PC monitors, ceramic substrates for mobile, emission control systems, filter plates for genomics, centrifuge tubes and laboratory filtration products. In addition, some firms offer digital platform for hands-free communication via secure text messaging, alert and alarm management that effectively solve healthcare communication and workflow challenges.

A couple of leading stocks within the industry are Arista Networks, Inc. ANET and Corning Incorporated GLW.

Here are the three major themes in the industry:

•    Telecom service providers are increasingly leaning toward fiber optic cable in order to meet the burgeoning demand for cloud-based business data and video-streaming services. Moreover, fiber-optic cable network is vital for backhaul and last mile local loop, which are required by wireless service providers for the deployment of 5G network. Fiber networks are also essential for the growing deployment of small cells that bring the network closer to the user, and supplement macro networks to provide extensive coverage. 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. The 5G transition is expected to be disruptive in nature, potentially creating new avenues for industries across the board. 5G is likely to augment the scalability, security and universal mobility of the telecommunications industry, which is likely to boost IoT. The telecom firms are facilitating its customers to move away from an economy-of-scale network operating model to demand-driven operations by offering easy programmability and flexible automation. The industry remains well poised to meet these evolving trends, given its technology prowess, product depth and wide applications.

•    The industry participants are transforming the entertainment experience through a holistic approach to content delivery in order to help providers anticipate demand for more personalized, relevant and mobile experiences. Voice-powered interactions are fast emerging as a critical and necessary feature as consumers tend to engage with technology through natural, spoken commands across the mobile, ear and IoT platforms. This has led to a wide array of products ranging from mobile phones to headsets, and from smart speakers to household appliances. Moreover, the firms offer a variety of pathways for offering 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 home. Some firms are also benefiting from the expanding cloud networking market, primarily driven by strong demand for scalable infrastructure, which has become necessary for new applications and services. Apart from delivering high capacity and availability, cloud networking promises predictable performance along with programmability that enables integration with third-party applications for network, management, automation, orchestration and network services.

•    Consumer demand for faster Internet speeds with more capacity continues to grow at an escalating rate, primarily driven by increasing consumption of video. The wide proliferation of cloud networking solutions is further resulting in increased storage and computing on a virtual plane. As both consumers and enterprises are using the network more, there is tremendous demand for quality networking equipment. Moreover, demand for faster data transfer is fueling growth of optical networks. Although the industry participants strive to maintain manufacturing facilities in close proximity to direct customers, they remain exposed to volatility in commodity pricing. Fluctuations in commodity pricing for various metals, such as palladium, gold, brass, stainless steel and copper often affect the profitability of the sector. In addition, in order to hedge the competitive pressure, the industry participants are forced to invest significantly in R&D to come up with innovative technology solutions. This, in turn, leads to escalated costs, which often are passed on to customers, sometimes resulting in intense price wars and  margin contraction. Moreover, supply-chain disruptions due to latent Sino-U.S. trade hostilities and the cascading effect of the coronavirus outbreak in China have affected the delivery schedule of most companies. This is largely due to the fact that several companies are increasingly preferring to exercise caution and hold their delivery schedules to and from the communist nation until the health risks are neutralized.

Overall, despite inherent potential, the industry appears to be mired in near-term headwinds that cloud its prospects.

Zacks Industry Rank Indicates Bleak Prospects

The Zacks Communication - Components industry is housed within the broader Zacks Computer and Technology sector. It carries a Zacks Industry Rank #167, which places it at the bottom 35% 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 encouraging prospects. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

The industry’s positioning in the bottom 50% of the Zacks-ranked industries is a result of negative earnings outlook for the constituent companies in aggregate. Looking at the aggregate earnings estimate revisions, it appears that analysts are losing faith in this group’s earnings growth potential. The industry’s current-year earnings estimates have declined 22.9% over the past year, while that for the next year is down 39.2%.

Before we present a few communication components 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 Sector and S&P 500

The Zacks Communication - Infrastructure industry has lagged the broader Zacks Computer and Technology sector as well as the S&P 500 composite over the past year, largely due to near-term challenges.

The industry has declined 3.7% over this period against the S&P 500 and sector’s rise of 20.7% and 29.5%, respectively.

One Year Price Performance

Industry’s Current Valuation

On the basis of trailing 12-month price-to-book (P/B) ratio, the industry is currently trading at 3.20X compared with the S&P 500’s 4.66X. It is also below the sector’s trailing-12-month P/B of 5.74X.

Over the past five years, the industry has traded as high as 3.50X and as low as 1.03X and at the median of 2.38X, as the chart below shows.

Trailing 12-Month Price-to-Book (P/B) Ratio

Bottom Line

With gradual deployment of 5G technologies, fiber optics and massive proliferation of data traffic, the industry boasts inherent growth potential. However, high operating expenses, trade irritants, supply chain adversities and coronavirus impact appear to impede growth.

Two stocks in the space currently carry a Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

SeaChange International, Inc. SEAC: Founded in 1993 and headquartered in Acton, MA, this communication components manufacturer has gained a solid 143.5% over the past year. The Zacks Consensus Estimate for current fiscal-year earnings for this stock has moved up 850% over the past 90 days.

Price and Consensus: SEAC

Spirent Communications plc SPMYY: Founded in 1936 and headquartered in Crawley, the United Kingdom, this communication components manufacturer has gained a healthy 74.5% over the past year. The Zacks Consensus Estimate for current and next fiscal-year earnings for this stock has moved up 23.3% and 25%, respectively, over the past year.

Price and Consensus: SPMYY

We are also presenting two stocks with Zacks Rank #3 (Hold) that are well positioned to grow.

Communications Systems, Inc. JCS: Headquartered in Minnetonka, MN, this communication components manufacturer has gained a stellar 167.6% over the past year. The Zacks Consensus Estimate for current fiscal-year earnings for this stock has moved up 1450% since May 2019.

Price and Consensus: JCS

EXFO Inc. EXFO: Headquartered in Quebec, Canada, this communication components manufacturer has gained a modest 16.3% over the past year. The Zacks Consensus Estimate for the current fiscal-year earnings has moved up 71.4% over the past year.

Price and Consensus: EXFO

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