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Still Work to Do at JDSU

Consider what you're willing to pay for coming improvements.

Editor's note: This column is a special bonus for readers. It first appeared on Street Insight on Nov. 2 at 7:13 p.m. EST. To sign up for Street Insight, where you can read Dvorchak's commentary in real time, please click here.

Investors warmly welcomed



first pro forma profit in years, bidding the stock up in early trading.

Last night, the company

reported an "upside" surprise for its first quarter, with pro forma earnings of 3 cents a share vs. the penny a share that Wall Street expected.

The market's reaction is a bit odd, as sales missed consensus, coming in at $318 million vs. the Street's expectation for $322 million. Investors may be cheering some margin improvement. However, if JDSU could beat the earnings estimates on light revenue, it would've posted a larger beat had revenue been in line.

JDSU still has work to do because the profit came from interest earnings on its prodigious cash hoard of $1 billion. The company is not yet operating profitably, but management has been guiding to that next quarter. Revenue guidance was unchanged, so investors need to assume that margin expectations are unchanged as well.

Optical communications dominated the revenue, bringing in $138 million, yet it produced only $2 million in operating income. Optical communications is a low-margin business, with gross margins below 30%, according to management.

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Meanwhile, the higher-margin test and measurement (T&M) business was knocked down by carrier consolidation. Management revealed that the T&M sales pipeline is robust, and it expects revenue to bounce next quarter.

Management believes the company can move to a "model" of 40% optical communications, 40% T&M and 20% other in the near term, which would boost margins meaningfully. It points out, however, that this model is only an interim milestone, because it won't produce acceptable levels of profitability. At 40-40-20, operating margins still only come in at 2% to 5%.

Fixable Internal Issues

Management also revealed that part of the T&M shortfall was due to internal issues, specifically a move to


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enterprise resource planning, which caused hiccups just as orders were surging in a back-end-loaded quarter.

The fact that fixable internal issues could be holding back T&M revenue should give the Street great comfort in the guidance. The outlook already bakes in ongoing pauses in carrier buying that have recently affected T&M.

Net-net, the "optics" on margin and earnings improvement are clearly "visible." There is definitely light at the end of the tunnel, but investors need to consider carefully what they should pay for the coming improvements.

This stock is still very highly valued considering how poor absolute performance is, and the company must string together years of steadily improving results to generate any sort of interesting return in the stock. Caution is warranted.

At the time of publication, Dvorchak had no positions in the stocks mentioned, although holdings can change at any time.

Gary Dvorchak is a managing partner of Global Financial Private Capital, a Sarasota, Fla.-based institutional asset manager that manages $140 million in growth and value equities and fixed income. Dvorchak holds a master's degree in business administration from Northwestern University and a bachelor's degree in computer science from the University of Iowa.