Investments become more selective

BY ROBERT MANDRA AND KEVIN SLOCUM

Given the continued challenges in the sector, we were left expecting little more than sideways trading until later this summer.

In May, we hosted Photonics 2001, the fourth annual Wit SoundView optical communications conference. The biggest upside surprise was the number of attendees, approximately 500, which is about the same as a year ago. Not that we expected to hear anything different, but there was little to cheer about from presenting companies or others in attendance. We came away concerned that most stocks in the sector had rebounded well ahead of a turn in fundamentals.

In mid-April, we highlighted to investors how the photonics sector seems to trade as a group with only modest stock-to-stock variations. The rally from the April lows produced a similar group move. If that were going to continue to be the case, we speculate the best that could be expected from the sector through summer's end is a sideways consolidation. We still believe that investors will begin to invest more selectively in the sector, driven by far greater disparities in financial performance.

Under that scenario, we expect Ciena, Digital Lightwave, and Finisar will deliver further gains from the mid-May levels over the balance of the summer and year. We suspect that ONI Systems will do the same, but we don't yet have active coverage, so we hold back on further comments there until we initiate formal research coverage of the company.

Our reaction to the first quarter reports was that we might see some optical-component companies hit bottom in the June quarter followed by flat sequential revenue in the September quarter and possibly even a modest up-tick. Among the guests at our conference were a number of private companies that supply the likes of Agere Systems, Corning, and JDS Uniphase. Based on what we heard from the presenters and some of the other conference participants, we are inclined to believe that September results are more apt to provide that bottoming out. With most of the component companies having rebounded since March results were aired, we believe this longer path to a rebound will produce bouts of negative worries and sideways seesawing in the stocks through the summer.

Finisar was one of the only component bright spots. Given that today Fibre Channel substantially drives its business and thus enterprises-not carriers-it is very distinct from all the other component companies in attendance. The company continued to believe that it was probably halfway through a six-month correction, placing the company on track for better news by late summer. They also reiterated strong interests from customers for its 10-Gbit/sec serial transceiver. For those looking for positive incremental news, the company also spoke of accelerated demand from its cable customers for the digital reverse-path product that was designed-in by three major industry suppliers last year. That, coupled with moderately more optimistic comments from its Fibre Channel customers, was encouraging.

We mentioned at the conference that our preferred large capitalization recovery speculation was JDS Uniphase. We nonetheless believe investors will be able to accumulate the shares below $20 for a move over the next 12 months to the high $20s and maybe low $30s, if we don't see slippage from that September quarter bottom out. We also highlighted LightPath Technologies, but the same problem of squishy near-term revenue growth hampers our being as aggressive as our strong buy rating implies. As we have in previous columns, we offered positive comments on Bookham Technology. These comments came in connection with the promise of optical integration, in which a strong cash position should get the company through the current trough. That, when coupled with our belief that the company's integration platform will find substantial opportunity as we move past the current market problems, led us to believe the stock will stage a nice rebound later this year in anticipation of better times next year. Bookham also faces the same troublesome near-term demand environment as everyone else in the industry.

Newport, EXFO, and Digital Lightwave were the public infrastructure companies that presented at the conference. Agilent had planned to come, but cost-containment efforts changed that. The story in this area of the business has been backlogs resulting in healthy near-term performance but real concern about what lies beyond. For Digital Lightwave, we don't harbor that same concern. The important role their gear plays in provisioning new wavelengths, along with the broader adoption of OC-192 technology throughout carrier networks, led us to believe it can replace shipped backlog and grow at least in line with our estimates throughout this year.

At Newport and EXFO, the concern applies. EXFO still seems confident it has visibility through the end of its August fiscal year. That's not bad given what has been going on, but the company's hesitancy to give guidance beyond that timeframe is enough for us to advise building positions on weakness. For Newport, we came away from the conference more nervous about the company's financial performance, and we have cut our rating to a hold today and cut numbers once again.

We didn't exactly have a lot of system players in attendance this year. Lucent Technologies and Nortel Networks were there in each of the past three years. Lucent declined to attend because of an acute focus on righting itself, which has management believing this is not the time to be doing investment conference presentations. Nortel told us they had conflicts that made it impossible to attend. Maybe the management changes announced the morning after the conference were all the explanation that was necessary. Sycamore felt the imminence of its April report, coupled with the dramatic change in outlook, made its decision not to present the best choice. That left the stage pretty much uncluttered with competitive system stories for Ciena, and maybe appropriately so, given how distinctive its performance seems to be these days.

The optical communications market continues to hold substantial promise. Comparable year-to-year attendance at our conference is a great indication that investors share that view. However, the carrier industry challenges that have undermined that opportunity in the near-term do not appear as though they will loosen their grip easily. If investors hope to mine profits from the sector, we believe they will have to be very selective. We are most enthusiastic about the prospects for Ciena, Digital Lightwave, and Finisar. These and other investments in the sector will require patience.

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 analy-sis. He can be reached at (203) 462-7219 or at kslocum@witsoundviewcom.