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3 Communication Stocks Likely to Ride on Solid Demand Trends

The Zacks Communication - Components industry appears well poised to gain from healthy demand trends amid fading supply chain adversities with the gradual revival in post-pandemic market conditions and a faster pace of 5G deployment. However, large-scale investments for infrastructure upgrades to support the transition to 5G, high inflationary pressures and a challenging macroeconomic environment have led to intense volatility in raw material prices.

Nevertheless, Arista Networks, Inc. ANET, AudioCodes Ltd. AUDC and TESSCO Technologies Incorporated TESS 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

Convergence of Network Technologies: 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.

Demand for Scalable Infrastructure Escalates: 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 wide 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.

Eroding Profitability: With the exponential growth of mobile broadband traffic and home Internet solutions, user demand for coverage speed and quality has increased manifold. This has resulted in a massive demand for advanced networking architecture, in turn forcing service providers to spend more on routers and switches as carriers aim to upgrade their networks to support the surge in home data traffic. 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 shortages 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 escalate production costs. High technological obsolescence of most products has also escalated operating costs with steady investments in R&D. However, with various administrative and federal support along with the ramp-up in production facilities for chip manufacturing, the demand-supply imbalance is likely to ease gradually in the upcoming quarters.

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 #42, which places it among the top 17% 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 Outperforms S&P 500, Sector

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

The industry has lost 18.9% over this period compared with the S&P 500 and sector’s decline of 20.9% and 38.7%, 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 3.1X compared with the S&P 500’s 5.24X. It is also below the sector’s trailing-12-month P/B ratio of 4.27X.

Over the past five years, the industry has traded as high as 4.31X, as low as 1.99X and at the median of 3.04X, 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 Networks: 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 90.2% in the past two years. The Zacks Consensus Estimate for the current and next fiscal earnings has been revised 22.7% and 26.6% 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 provides routing and switching platforms with industry-leading capacity, low latency, port density and power efficiency. The company also innovates in areas such as deep packet buffers, embedded optics and reversible cooling. Arista currently sports a Zacks Rank #1 (Strong Buy). You can seethe complete list of today’s Zacks #1 Rank stocks here.

Price and Consensus: ANET

AudioCodes: Incorporated in 1992 and headquartered in Lod, Israel, AudioCodes offers advanced communications software, products and productivity solutions for the digital workplace. Its product portfolio includes session border controllers, life cycle management solutions, VoIP network routing solutions, media gateways and servers, multi-service business routers, IP phones solutions and value-added applications, as well as professional services.  It has a long-term earnings growth expectation of 9%.

AudioCodes is likely to benefit from the secular tailwinds related to IP-based communications. It aims to leverage its long-term partnership with Microsoft to further strengthen its market position. AudioCodes is also likely to benefit from its continued focus on high-margin businesses. It sports a Zacks Rank #1 at present.

Price and Consensus: AUDC

TESSCO: Headquartered in Hunt Valley, MD, TESSCO offers base station antennas, cable and transmission lines, along with fixed and mobile broadband radio equipment. It delivers complete end-to-end solutions to the wireless industry. The Zacks Consensus Estimate for the current-year earnings of this Zacks Rank #1 stock has moved up 44.3% since November 2021.

With the completion of the sale of the retail business, it is likely to be better focused and more growth-oriented. TESSCO has multiple growth drivers over the next several years and is poised to benefit from the faster 5G rollout 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

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