Will winter of discontent lead to optimism?

Though we're certainly beyond the high multiples of prices at which many companies were discovered, the real sorting out for success is just beginning.

BY KEVIN SLOCUM and ROBERT MANDRA

From the fall of 2000 through the winter of 2001, the optical-communications sector has been bludgeoned, even though most of us who are close to the industry are very optimistic about the opportunities at the outset of that period. We, like those others, have suffered a bad case of what turned out to be over-optimism. For many investors, the lesson seems to be that there is a secular problem for the sector that will leave the landscape littered with carriers, system manufacturers, and component companies that will have to be consolidated or closed down.

We spent the few days before writing this column meeting with 45 investors from 36 different institutions, fielding their concerns about the health of the sector and why they were not going to be involved in the group for some time. Few investors could accept that the problems were due to a cyclical slowing tied to the toll of rising rates over the course of 2000. Most investors were focused on secular challenges they believed would not be easily resolved. In the end, we couldn't wait to go home where we would face the real world of young children and all the optimism they hold and project.

It is funny how a year or so changes thinking. It was not long ago that the profound changes that faced carrier networks were expected to produce phenomenal opportunities for those involved. There was little attention spent on the disruption the changes would produce and if anyone chose to talk about them, they would be totally ignored and in all likelihood would have jeopardized their short-term career prospects. In the early part of this year, the shoe is on the other foot.

Technology and the change it brings are never quite as great nor as bad as we close to it perceive. It is very typical for the opportunities it spawns, large and small, to go through a hype phase, then transition back to reality and re-emerge with more sustainable expectations. In a recent example, the Internet economy marched through this process and now so is optical communications. There is almost always this euphoric period where the opportunity sinks into the heads of investors and demand runs well ahead of the limited estimates of the scope of the emerging market. At that point, investors just scramble to own anything associated with the opportunity.

Over time, critical mass is achieved, with better market forecasts and a clear picture of the real industry participants. Those that can be negatively impacted by the change become a greater focal point in terms of what they are doing to sustain their market position in the face of the new challenge. You start to have winners and losers. With that comes disappointing earnings and the greater need to separate company hype and truly understand the changing landscape. Throw in some macroeconomic factors such as rapid expansion or a slowdown like the one that seemed to hit the U.S. economy in late 2000 and more importantly early 2001, and the sorting-out process can get pretty challenging. But from these conditions emerge clear leaders and most often great investments.

Optical communications is barely past that hype phase. Only a year ago, anything that had optical associated with it was up five-, 10-, or even 20-fold. Well, we are certainly beyond the high multiples of prices from where many companies were discovered, but the real sorting out of the potential for success is only beginning. Up to this point, the pull back has been largely across-the-board selling tied to concerns that the opportunity may be more limited than was perceived. How much of the investment that went on in the telecommunications markets over the past few years was because it was necessary? How much was because you could get away with it and the carrier trusted there would be a payoff? In the slower climate, how much of the cutting we're hearing about is because that is what the carriers feel they need to say in tight capital-availability climates as opposed to it being in the best interests of the business? How much is the true cutting of projects that had enough uncertainty about them that they deserved to be cut until a clearer understanding of their contribution is available? These types of questions have investment professionals heading for the sidelines.

The move to optical networking will have profound effects on the economics of communication. We believe optical networking will change the structure of the carrier markets as importantly as deregulation, the globalization of the economy, and the Internet. Those changes will cause disruptions to many existing companies, failures among the newly public companies and startups, and great new success stories. In the last six months, the market has shifted all its focus to the first three sets of possibilities, and there has been a seeming inability to comprehend how there could be any success stories. The sorting out of the potential for success will take varied amounts of time for all of the players, but as this year and next wears on, we expect winners will start to emerge and with them renewed optimism for optical communications.

Professional investors are reviewed with such a strict short-term focus, it is hard for many of them to buy stocks that are down unless they see a catalyst that is likely to make the price they paid today look brilliant tomorrow. That means in an environment like the one we have lived through in early 2001, investors have to contain their losses and hold off making purchases of the shares they may believe are very attractive until they can find that catalyst. For the rest of us, certainly we would like the price we paid today to be the low, but how can we know that? So you have to ask yourself the question, do you believe that late this year or early next year the prices you are paying for stocks in the optical-communications sector today will look pretty darned attractive even if numbers have to ratchet down once again? If the answer is yes, you should be buying the stocks today with the knowledge that the pros will be coming back when the coast is clear, making your purchase price look all that much better.

We want to say in closing that we feel as good about buying shares in our sector as we have since the fall of 1998. That doesn't mean we expect the same sort of run ahead, but we believe there will be some real winning investments from the late winter lows over the next 12 months. Our favorites are Bookham Technology (despite the show-me attitude of investors toward the company), Ciena, Cisco Systems, Finisar, and a company we haven't previously mentioned, LightPath Technologies.

Kevin Slocum is a managing director and communications research analyst for Wit SoundView (Stamford, CT). He has more than 18 years of financial industry experience, including equity research, sales, and analysis. He can be reached at (203) 462-7219 or at kslocum@witsoundviewcom.

Robert Mandra is a principal in investment banking with Wit SoundView (Stamford, CT). Previously, he was an optical engineer with MIT Lincoln Laboratory for nine years. He can be re ached at (203) 462-7361 or at [email protected].