No relief in sight for optical components sector

by Meghan Fullert Hanna

The week kicked off with the Optical Society of America (OSA)/Lightwave-sponsored Executive Forum, which featured a formidable gathering of some of the component industry�s biggest names, including Alain Couder, president and chief executive officer of Bookham; Jo Major, chairman of the board, president, and CEO of Avanex; Mike Nishiguchi, president and CEO of ExceLight Communications; Jerry Rawls, chairman, president, and CEO of Finisar; Rueben Richards, president and CEO of EMCORE; Joseph Liu, president and CEO of Oplink Communications; and Fariba Danesh, senior vice president and general manager of Avago Technologies. All agreed that consolidation among component vendors is required to reduce duplicative R&D, eliminate SG&A, and restore vendor pricing power. Amazingly, though, none of them believe that this much-needed consolidation will occur in the 2008 calendar year. Is it simply a matter of ego? Many industry insiders contemplated that question during the week-long event, but few came up with any solid answers.

Here�s what we do know:

• Gross margins remain tight at 20% to 30%.
• The component industry has experienced revenue growth and improving profitability over the last year, but the disrespect from Wall Street has not changed.
• No one knows which part of the optical telecom food chain should bear the brunt of the R&D burden.

As in years past, OFC/NFOEC 2008 featured a Market Watch session on the state of the optical industry, and this year�s installment was entitled, �Achievements, Challenges, and Path to Profitability.� It proved particularly interesting as opinions among the panelists ranged from �It�s not that bad,� to �It�s a train wreck [driven by] mismanaged companies doing stupid things over and over and over again.�

The �glass-half-full� panelists, including Paul Bonenfant, communications components analyst, Equity Research, at Morgan Keegan (www.morgankeegan.com), argued that there are pockets of opportunity in the market. Segments that are expected to trend upward during the 2006�2012 timeframe are also �component heavy,� said Bonenfant, and include aggregation, WDM, and submarine. Morgan Keegan believes the aggregation market will grow from $6 billion to $6.5 billion during the forecast period, while the WDM market will increase from $4 billion to $9.6 billion. The submarine market will jump from its $300 million mark in 2006 to $1 billion by 2012.

In short, Bonenfant argued that the total addressable market for optical components should grow to the tune of $3 billion�from $5 billion to $8 billion�over the forecast period, driven by an increase in 10G, 40G, and reconfigurable optical add/drop multiplexer (ROADM) deployments. Bonenfant�s analysis suggests that the 10G market will grow from $1 billion to $1.5 billion, while the 40G market could increase from $20 million to $1 billion, a whopping 90% compound annual growth rate (CAGR). And, by his own admission, he has likely �underestimated� ROADM market growth, noting that it could increase more than his forecasted $120 million to $350 million from 2006�2012. �This is not the CAGR of an industry in secular decline,� he maintained.

That said, Bonenfant acknowledged that the component industry today is highly fragmented. The top 11 vendors comprise 65% of the market with only 9% separating No. 1, JDSU, with a 12% market share, from No. 11, Optium, with a 3% market share. In other words, he too believes the market is ripe for consolidation.

Bonenfant wondered if perhaps Wall Street itself is to blame. The investment community rewards service providers because it likes to see dividends paid every quarter, but this requires the service providers to have a high free cash flow. And that forces the providers to spend less and yet ask for more from their equipment suppliers, who ultimately put the squeeze on the component vendors.

Ending his presentation on a high note, Bonenfant argued that end market demand seems to be improving, and vendor operating models are beginning to show leverage. And while depressed valuations make the likelihood of an IPO this year rather small, he cited two key partnerships as the beginning of a potential trend that would see larger vendors, not VCs, pouring money into R&D.

JDSU (www.jdsu.com) announced last October that it has partnered with Mintera (www.mintera.com) to co-develop 40 Gbit/s products, starting with a 300-pin transponder module to be based on Mintera�s adaptive differential phase-shift keying (ADPSK) modulation scheme. As part of the partnership, JDSU has invested an undisclosed amount in Mintera.

Finisar (www.finisar.com), meanwhile, announced at OFC/NFOEC that it has entered into an agreement with Nistica (www.nistica.com) to market through its sales channels all the vendor�s ROADM components. (In a separate interview with Lightwave�s editorial director Stephen Hardy, CEO Jerry Rawls admitted that Finisar initially wanted to purchase Nistica, but the company was not for sale.) Finisar also contributed to Nistica�s latest funding round.

Sharing the dais with Bonenfant was Todd Kauffman, managing director of equity research at Raymond James & Associates USA (www.raymondjames.com), who began his presentation by noting that the optical network industry has lost 45% to 50% of its value over the last 5 years. �From an equity value perspective,� he said, �it�s hard to make a case that it�s an attractive place to work or invest. Basically, everyone loses money.� He then characterised the industry as �a train wreck� driven by �mismanaged companies doing stupid things over and over and over again.�

Kauffman believes the problem is threefold: 1) too many players; 2) boards that are indifferent or incompetent; and 3) managements that are not shareholder friendly. And he too pointed a finger at the capital markets, arguing that they are won over by the macro-story of ever-escalating bandwidth demand. As a result, round after round of investors are �wiped out� and replaced by �a new group of idiots,� he said.

He reported that the system vendors, by and large, are recording gross margins of around 60%. If gross margins are a good metric for how much intellectual property a company has, how many competitors it faces, etc., then the component vendors, by contrast, are in tough shape. At roughly 30% gross margins, they are half as profitable as the system vendors. Kauffman listed JDSU at 38%, Avanex at 28%, Bookham at 24%, Opnext at 25%, and Optium at 30% gross margin.

For his part, Kauffman believes the real reason why the industry hasn�t seen the consolidation it so desperately needs is simple: �Ultimately,� he said, �it�s ego.�

Moreover, he cautioned several of the component companies� CEOs to �watch out,� because those with market capitalisation in the $150- to $200-million range seem ripe for a hostile takeover. At press time, that included Bookham at $152 million, Optium at $159 million, and Avanex at $180 million. (JDSU, by contrast, enjoys a market capitalisation of $2.9 billion, buoyed by its strong presence in the test and measurement segment.) While a less-than-friendly takeover would lead to �a potentially unpleasant and turbulent time,� Kauffman believes such activity ultimately will result in a much healthier industry.

Andrew Schmitt, general partner at Nyquist Capital USA (www.nyquistcapital.com), shared Kauffman�s sentiments, noting that the generally held belief that bandwidth demand is skyrocketing may be, in fact, a misconception. Using Japan as an example in part because the Japanese government compiles reliable data on FTTH usage, Schmitt reported that bandwidth usage there has not doubled. From 2004 to 2007, bandwidth usage per day experienced a CAGR of 38% for downloaded traffic and 29% for uploaded traffic. Schmitt wondered how much of this growth can be attributed to the increase in subscribers on the network; this year, FTTH subscribers will surpass DSL subscribers in Japan. It turns out bandwidth usage has increased 18% per year when you discount new subscribers.

At the end of the day, said Schmitt, aggressive deployment of FTTH is not driving bandwidth growth in Japan; even video is not registering. He argued that without a critical new application, profitable growth will be driven by the enterprise, not broadband traffic. �Let�s hope there�s someone in a dorm room developing the next Napster because that will save us all,� he said.

Like everyone else, Schmitt lamented the lack of consolidation in the component space, and he offered an analogy from the consumer electronics market. A few short months ago, many believed the high-definition DVD market had reached a stalemate: It was Sony and its Blu-Ray technology versus Toshiba and its HD-DVD format. Then Warner Brothers, which had been publishing its film titles in both formats, announced in early January its decision to release high-definition titles exclusively in Blu-Ray disc format beginning later this year. Less than two months later, Toshiba announced it would cede the market to Sony and discontinue manufacture of its HD-DVD players.

There�s an analogy to be made here, said Schmitt. If there were a big merger in the optical component space, the optical component landscape would undergo similar change. Everyone would be forced to act immediately, and other vendors would likely consolidate. Schmitt cited several possible M&A scenarios large enough to shake up the industry: Avago Technologies buying/merging with Finisar, and JDSU spinning out its optical component business to �vendor X.� The long-rumored Bookham/Avanex merger would do the trick as well.

If a market recession does occur, said Schmitt, then we will enter a phase in which liquidity matters more than technology. �If you don�t have cash in the bank, there�s not much you can do,� he said.