So why did a year that ended so good financially...

BY KEVIN SLOCUM AND ROBERT MANDRA

As 2000 had come to a close and optical communications companies looked forward to 2001, the simple answer probably heard from most analysts and shareholders to the perplexing riddle of good earnings yet not-so-good stock performance is that valuations just got too high. However, we're not inclined to offer the simple answer, because in some instances we do not believe that valuations were too high. We continue to expect companies that can make a significant difference in the cost of supporting high-bandwidth communications to command what some are describing as historically high valuations.

The trouble is that investors have been going through an education process in the fiber-optics arena. To most, the technology is still very new. Many of you have probably scratched your heads at the lack of discrimination that professional investors have exercised when deciding what to pay for your own company's stock and those of your competitors. Some companies' management has taken advantage of this naivete, while promoting their position and prospects-what we can probably call the hype phase. It happened in DSL, cable modems, e-commerce, and Internet infrastructure. Now, maybe it has come and in part gone in the photonics sector.

More important than the hype is that we are going through gut-wrenching change in the communications services business. The change is far more dramatic than the move to distributed computing. We all know what that change meant for IBM and the "Bunch Companies." Shouldn't the sort of problems we saw then be much more devastating in a much shorter period of time with the photonics revolution? Is it any wonder AT&T, MCI WorldCom, Lucent Technologies, and others are struggling?

We will see some companies disappear as we navigate through this process of moving to next-generation network architectures that can allow carriers to survive, while dealing with lower and lower pricing power for the services that they sell today. But just because it's hard doesn't mean we won't complete the process. For companies that move like there's no tomorrow to support and adopt these new technologies, the future is bright. The challenges of a higher capital-expenditure requirement to make the transition is just that, a challenge. It is not a show-stopper. It should pressure carriers to alter the processes they use to evaluate the new technologies and jettison the old solutions more rapidly. It should pressure the emerging system suppliers to grasp the carrier problem and come up with profound alternatives to how things are being done today. Component suppliers should take the steps necessary to deliver dramatic cost reductions for system customers, instead of playing to an agnostic one-stop-shop routine. And last but not least, investors need to start spending the time to understand what they own and why.

If the stock market travails of 2000 meant anything at all last year, we believe that they were a signal that the easy sledding is over and now the winners will be those that fix the real problem. We remember saying last year that we didn't know if it would be good enough to just be another thin-film-filter company in 2000. For half the year, our concern couldn't have been more wrong, given the NetOptix purchase by Corning and similar moves by other companies. But our concept was probably correct by the second half. New players in this field will have to add substantial value to the process of making filters. Otherwise, we should be unwilling to invest.

Maybe we should look at the situation in a little different vein. Up until last year, it seemed a riskless prospect to invest in a photonics company. Money was coming from every direction, and if you wanted a piece of a company, there was no time or even tolerance for due diligence. Therefore, investments in the ideas that seemed to have the greatest consensus of positive thinking to go with them, enjoyed the easiest path to funding. Now their lack of differentiation may leave them in a struggle to find new investors.

Two names that we were very enthusiastic aboutseemed to struggle for investor support last year because they were somewhat differentiated. The most striking was Bookham Technology. The company is doing something that is clearly unique, yet all investors could do was run to the purveyors of the solutions that would be threatened by Bookham's solutions to gauge the company's potential for success. The normal reaction should have been to be more interested because of the objections. We may be proven wrong in our enthusiasm for the Bookham story, but if they can actually deliver in volume the type of solutions that they have been announcing, the company will make a profound difference in the cost structure of optical-component solutions. Given the size of these markets, we'll make that bet as long as the evidence from customers, not competitors, continues to support our thinking.

The other company that had our attention was Finisar. We spent the better part of the year fighting a battle with investors about the company's gross margins. It didn't matter that the company's top line was exploding because of incredible demand for Finisar's transceivers. The fact that customers couldn't say nicer things was irrelevant. The long-haul optical system players such as Ciena and Sycamore Networks were talking about the growing importance of Gigabit Ethernet technology in their product offerings, but nobody seemed to put two and two together with Finisar-despite the fact the company was proving that it was one of the best in the business at working with this communications protocol and had the vision to tell you the technology would be important before any of these long-haul players did. Instead, the success or failure of the stock seemed to be driven by a fairly understandable decline in gross margins that was precipitated by overwhelming demand for the companies lowest-margin product line.

It was a tough year in the market for photonics stocks and we had our share of blunders as well a few successes. That is the way it should be. It should be tougher for you to fund your businesses, it should be tougher for us to get our stock calls correct, and venture capitalists shouldn't be able to make a 10-bagger on every bet in one-third the normal time. But the opportunity in 2001 is no less exciting or great for those that deliver.

We believe the pressure faced by carriers in the second half of 2000 will precipitate a more rapid move to the new switching technologies being delivered by Ciena and Sycamore. Last year, we said we feared Sycamore could knock the cover off the ball and fail to get any stock credit because so much good news had been priced into the shares. That turned out to be a good prediction, but as we look to the future, we believe it can be a good stock this year. Last year, we were not enthusiastic about Ciena initially, but we did move to a strong buy fairly early in the year and pounded on the story for the balance of the year. We're still pounding. This stock got hurt late in the year, and we believe the pullback was a gift for those who don't own the shares.

Acceleration toward new switching architectures is more mixed for Lucent and Nortel Networks. Each company has a foot in both generations of network architectures, and they were both punished to varying degrees for this straddle. In our view, Lucent's financial performance was so dismal last year that it's potential to rebound is completely discounted, yet we believe the company has a shot of making a reasonable comeback. As we write, the details of the restructuring were still not public nor was the new CEO announced, but we nonetheless believe that there was sufficient skepticism in the stock to make it attractive as a turnaround story in 2001.

Nortel is tougher because it was also pounded, even though its financial performance had been quite extraordinary in 2000. But stepping back and just looking at the company's optical position, we see more competition in the 10-Gbit/sec SONET equipment market. We believe that SONET gear generally should see slower growth, as confidence increases in some of the optical-switching alternatives. While the company has been gaining momentum in the metropolitan optical market, the profitability of this market is apt to be below that of long haul, and there is a crowd attacking the market. Finally, we don't believe the company's short-term prospects in optical switching are very promising. Nortel has said it will outgrow the optical market in 2001. We have a hard time seeing that, and therefore question the company's guidance. We view Nortel as more of a market call this year: If the market is strong, Nortel may do well; if not, you may rather make a bet elsewhere.

We haven't given up on the fiber market and with that Corning. We have also stepped up our enthusiasm for JDS Uniphase. Both companies could continue to struggle during periods of concern over business at Lucent and Nortel, but we believe Corning and JDS can overcome those concerns. On the smaller-company side of the ledger, maybe Bookham's and Finisar's differentiation will be an asset this year. We also recommend that you keep an eye on some of the newer 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 [email protected].