OFC/NFOEC 2007: Recovery underway, but incomplete

May 1, 2007

by Meghan Fuller

At last year’s Executive Forum, presented by Lightwave and the Optical Society of America (OSA) and held each year in conjunction with the OFC/NFOEC Conference, Philippe Morin, vice president and general manager of Nortel’s Optical Networks Division, caused a stir when he declared, “The mourning period for optical is officially over.” If this year’s event was any indication, the mourning period is officially over, but that does not mean a return to the heady days of 1999-2001. According to some industry insiders, the operating recovery is far from complete. Pricing remains competitive; gross margins are tight; the venture capital market is growing everywhere but in the US, it seems; and questions linger about how to fund R&D under these conditions. And the subject of consolidation-or lack thereof-may have come up once or twice as well.

Giorgio Anania, former president and chief executive officer of Bookham (www.bookham.com), perhaps best summed up the current state of the industry when he said, “The race for bandwidth is officially on.” And the high-bandwidth application everyone has their eyes on is video.

In his keynote address, Ryan Limaye, managing director and head of telecom investment banking at Goldman, Sachs, & Co. (www.goldmansachs.com), noted, “The industry is as healthy as it has felt since 2000, and the video build-out is really driving this.” Furthermore, he said, investment now is occurring in a much healthier manner, with demand preceding deployment. Capital expenditures have returned to a level more consistent with the historical average of 16% of revenues, he said, which is good news for the industry. However, he admitted, “We need video to work and make sense.”

The changing fortunes of the panelists from last year’s Executive Forum also were cited as a positive indicator. Last year, nearly all of the panelists were losing money; today, the majority are profitable, thanks to both cost cutting and increasing revenues. JDSU saw a 45% increase in revenue from 2005 to 2006, for example. Avanex watched its revenue increase 20%, and Finisar recorded a 25.9% revenue increase. Moreover, carriers now are launching new platforms that take advantage of new component technologies such as pluggable optics.

But not everyone is ready to proclaim the recovery complete. Andrew Schmitt, general partner at Nyquist Capital USA (www.nyquistcapital.com), offered a more sobering view of the industry in his presentation during OFC/NFOEC’s Market Watch Panel, “A Wall Street Perspective,” held later in the week. Revenue growth does not necessarily mean success, he said, adding that we have entered “an era of profitless prosperity.”

In his discussion about value creation and monetization in the optical module space, Schmitt stressed the need for further consolidation and the removal of fixed costs. He also reported that in several markets, the industry was leaning toward a monopsony. In a monopsony, market conditions are dictated by a single source, i.e., when the products of several sellers are sought by a single buyer. It is a highly inefficient market situation that destroys the competitive landscape, he explained. The monopsonist in the optical module space, Schmitt argued, is Cisco Systems, which purchases seven out of every 10 optical modules for Ethernet applications. Moreover, the company employs security measures that force customers to deploy only Cisco modules-which it resells at 90% gross margin with negligible value add-rather than standard MSA modules, Schmitt asserted.

The end result? Cisco recorded $1.2 billion in module revenue in 2006, which is equal to the 2006 revenue of JDSU, Bookham, Avanex, and Finisar combined. In short, said Schmitt, consolidation is necessary and will help “keep Cisco honest.”

Indeed, consolidation was an oft-heard buzzword in panel sessions and on the exhibit floor, with most people wondering the same thing: When?

Consolidation occurred among the service providers in late 2005/early 2006, and it occurred last year among some of the larger system vendors, most notably the mergers of Alcatel and Lucent and Nokia and Siemens, as well as Ericsson’s acquisition of Marconi. During his keynote address to the Executive Forum, Limaye reported that consolidation in the service provider space has resulted in savings of $10 billion dollars, thanks to the removal of 2% to 4% of combined spending overlap. It is, he said, the classic case of subtraction by addition: The merger between Alcatel and Lucent netted $1.9 billion in annual savings, while the merger of Nokia and Siemens is expected to net $2 billion in annual savings. While this may be bad news for the vendor community, the overall health of the service provider community has improved as a result.

Limaye believes this consolidation will continue in the system vendor space, as the smaller service provider community will support fewer suppliers than previously. He expects the current 15 to 20 suppliers to be whittled down to less than five.

Meanwhile, consolidation continues to put pressure on component vendors. Pricing remains unstable and margins tight, noted Anania. However, markets in which there are only a couple of suppliers (e.g., pumps and amplifiers) are financially stable and suppliers profitable. In more competitive markets, by contrast, suppliers have seen “stupid” price reductions, he said.

Avanex (www.avanex.com) chief executive officer Jo Major agreed, noting that component vendors would do well to invest in segments where there are only two or three players. In such markets, vendors can attain gross margins in the 60% range. But where there are 10 to 15 players, gross margins are around 10% to 15%. Like many others, he argued in favor of further industry consolidation.

Since the bubble, consolidation in the component space has occurred on an opportunistic basis, typically an example of the big acquiring the little. But what we really need, said Schmitt, is the “big guys” (an Avanex and a Bookham, for example) to merge with each other. Such consolidation would restore vendor pricing power and eliminate selling, general, and administrative (SG&A) expenses. Schmitt also argued in favor of consolidation because it would eliminate duplicative R&D.

And therein lay another key topic at this year’s event: Given such competitive pricing and tight margins, where will component vendors find the money to invest in the requisite R&D to take the industry from 10G to 40G to 100G and beyond? Carriers and system vendors alike demand ever lower prices but an increasingly higher level of innovation and integration.

Jerry Rawls, chairman of the board, president, and chief executive officer of Finisar Corp. (www.finisar.com), admitted that given current margin levels, “it is impossible to deliver the level of R&D expected by our customers.” The challenge, he said, is to determine which opportunities fit each company best, for no company can pursue them all. If possible, companies should fill holes with strategic partnerships or acquisitions, he said, citing Finisar’s recent acquisitions of Kodeos Communications and AZNA LLC, both of which bring considerable R&D assets to the company.

Fariba Danesh, vice president and general manager of the fiber-optics division at Avago Technologies (www.avagotech.com), argued for further standardization to help focus R&D. The optical communications industry is nowhere near the level of standardization that other industries enjoy, she said. And although she believes volume is consolidating around X2 and XFP, Danesh noted that there are still four or five form factors shipping in volume for 10-Gbit/sec applications, and the R&D dollars are split among them.

When asked why consolidation has not occurred in the component space, John Dexheimer, partner with First Analysis Private Equity (www.firstanalysis.com), noted that there is still money in the system, be it extra liquidity from the optical boom or vendors restructuring and/or successfully completing series E, F, and G rounds.

Dexheimer also cited the increasing popularity of Private Investment in Public Entity Securities, or PIPES, as another reason why the big companies have not consolidated. Relatively easy and inexpensive to obtain, PIPES can guarantee as much as 10% to 15% in annual return, he reported. In fact, Dexheimer claims that there is currently more money in the PIPES market ($27 billion) than the VC market ($25 billion).

On the subject of VC investment in telecom, Dexheimer confirmed that it is “not coming back any time soon.” Communications today represents just over 10% of VC money invested versus 25% in 2000, he said. What’s more, Dexheimer estimated that 90% of initial public offers (IPOs) are now taking place outside the US, where the VC market is growing dramatically.

Dexheimer cited three recent IPOs of note that occurred outside the US, including Arasor (www.arasor.net), Ignis Photonyx (www.ignis.com), and Enablence Technologies (www.enablence.com). Arasor, an optical equipment manufacturer based in Mountain View, CA, debuted on the Australian stock exchange in October. Along with Italian partner Pirelli Broadband Solutions, Arasor sells optical equipment to Huawei Technologies in China. Ignis Photonyx, subsidiary of Ignis ASA, conducted its IPO in Norway. The company has additional operations in Denmark, Canada, and South Korea and has emerged as a key supplier of optical splitters and other components to Korea’s FTTH market. And Enablence went public in Ottawa (via a reverse takeover), sells diplexer transceivers into the Japanese market, and recently purchased a high-speed optical component manufacturer in Switzerland, Albis Optoelectronics AG. According to Dexheimer, such globalization would have been “hard to imagine six years ago.”

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