A shrink-proof industry?

April 1, 2007

by Stephen M. Hardy

One conundrum of the optical communications industry that continues to stump observers and participants alike is the issue of consolidation-or, more precisely, the lack thereof, particularly in the components/subsystems space. Carriers have consolidated, and system vendors, as evidenced by the Alcatel-Lucent merger and the Siemens/Nokia hook-up, have begun to follow suit. At the component/subsystem level, however, everyone appears to agree that too many companies continue to chase too few business opportunities. Of course, people have commented on this fact for at least the last 5 years. Still, even as the week of OFC/NFOEC began with news of three component/subsystem-level acquisitions-Finisar’s agreements to purchase AZNA and Kodeos, followed closely by Optium’s announcement of its acquisition of Kailight-the overall viewpoint remains unchanged. More mergers and acquisitions need to take place before the industry can “right size” to a rational number of players.

So what’s holding things up? The OSA/Lightwave Executive Forum offered some clues-clues that indicated that factors intrinsic to the optical communications field and to the customers it serves may pose high enough barriers to consolidation to prevent the industry from ever reaching the “right” number of participants. In fact, these factors, if fully considered, may change the idea of just what number represents critical mass.

Certainly one can list several factors that should drive a large number of companies out of the components and subsystems market in the near term. First, while the market has begun to pick up, it’s still not healthy enough to support a bubble-era competitive landscape. (In fact, one could argue the industry’s recently concluded problems stemmed in large part from the fact that the bubble itself wasn’t large enough to sustain the bubble-era competitive ecosystem.) Second, just as their customers seek to reduce operational expenses, system houses wish to shrink their own opex by limiting the number of suppliers they must engage. Third, with the market having stabilized now is a good time for VCs and other investors to force their companies to reconsider an exit strategy that might involve being acquired.

Forum participants, who included not only high-level executives from component companies but observers from the financial and customer arenas, harped in particular on the first two of these motivations for consolidation. For example, some of the major component players justified their support of broad product lines with the explanation that with system houses looking to trim their roster of suppliers, the ability to meet a wide variety of needs was essential for survival. This philosophy has been espoused for some time as the “one-stop shop” approach to the market, and companies such as JDSU, Bookham, and others have attempted to implement this philosophy with varying degrees of success.

However, the same panelists emphasized that the key to future fiscal health and success was a focus on the areas where they could maintain a competitive differentiation. Needless to say, unless a company has unlimited financial and personnel resources-and not even JDSU has this kind of weight to throw around-it can’t differentiate everywhere. Thus, major system houses can reduce their supplier counts to three or four for each of their product lines. But when they aggregate the supplier lists for all of those products, they’re likely to find that they still must deal with 10 or more vendors, like it or not. Differentiation and product line expansion clearly conflict, particularly in an environment in which R&D dollars can’t be spent indiscriminately. Some companies will attempt to solve this problem through acquisition, and the recent M&A activity described earlier illustrates relevant examples. (I didn’t say M&A would stop, just that it won’t result in a market size most people appear to want.) But there are only so many differentiated product lines a single company can support without swamping itself. As one forum participant observed, “No one talks about the one-stop shop anymore.”

System houses and the customers they serve also must share the blame (if one can call it that) for the unexpectedly large number of component/subsystem suppliers that continue to hang on in the market. That’s because the forum participants revealed that these parties continue to insist on customized products, even when dealing with areas where standards (or at least multisource agreements) are in place. Again, how many customized variants of each product can a single supplier support? As long as system houses and their customers require nonstandard products, the market will require a larger number of suppliers to fill the need.

I have said in this space previously that 2007 will see a significant amount of consolidation. I still believe this will be the case. However, I also believe that observers and participants will continue to lament that there are too many companies making components and modules, regardless of how much M&A goes on. And the industry has itself to blame.

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