Business that is won profitably at very aggressive prices will be a winning investment story.
BY KEVIN SLOCUM
We have been struck by some recent conversations that a stronger realization of how different the future for optical communications will be than the past has really not yet set in. It is important that component and system companies wake up to the new reality and adjust their business plans accordingly. A few months ago, we talked about the need to do something more dramatic than the same cost cutting as the other guy. Ciena buying ONI Systems qualifies as more, and maybe even Bookham Technology buying Marconi's optical-component operations does, as well. By the time you read this column, we suspect there will be other actions to mention.
The difference we reference is taking actions that can produce a meaningful improvement in business prospects in the absence of a strong rebound in the economy and spending by carriers. Like the Ciena-ONI situation, the actions could be a business combination, but more to the heart of what we see is that price will emerge as a key weapon for winning business in the coming years, and business won profitably at very aggressive prices will be a winning investment story.
Over the past few years, we have downplayed the level of innovation that took place in the optical communications sector. Once past the adoption of DWDM technology, most success grew out of strong execution and focus as opposed to very important technological contributions. We went through 1999 and 2000 more in the mode of technology risk avoidance. That made sense because demand was strong and the capital markets were wide open. Lucent Technologies in some respects took technology risk in the WaveStar OLS 400G, and the cost was a dismal performance from the product line and lost footprint in key customer networks. If Lucent could have done it over, we are certain the company would have made some less risky architectural decisions about the product.
It was easy for the financial community to look at the industry and its systems in 2000 and see that the embedded cost of these systems could be engineered to much lower levels, but the boxes worked and the customers were not clamoring for lower prices. They were demanding more capacity ASAP. As new companies entered the market, they painted a picture of vast differences in their platforms, but the truth was that the boxes were not very distinctive in cost structure or functionality.
Success grew from targeted marketing to key segments of the market. Corvis went after ultra-long-haul, and ONI Systems chose to target the metro market needs of carriers. Few seem to have created enough of a difference to sustain their stories. Even ONI, which built a number one position in its served market, ultimately decided that an acquisition by Ciena would be better for shareholders than continuing on its chosen course. Together, the two companies may be able to deliver a more substantial value proposition to customers and maintain some measure of advantage over other competitors.
We are convinced that a new crop of startups and a few redirected older ones will drive the price wedge into the market. We haven't spoken very optimistically about startups in a while, but we still believe they hold the keys to more of the promise of the future than the larger companies that grew out of the industry boom of 1999 and 2000.
The level of price reductions is also important. JDS Uniphase's promise of 25-30% annual price reductions is not enough. If a company is going to have any chance of getting business back on track, we need a 70-80% drop in current system costs and the underlying components, followed by 25% annual savings moving forward. There are companies that feel they sit in this position and with the prospect of very healthy margins despite the new pricing levels we are mentioning.
As an example, we have met with BaySpec, a Fremont, CA, company that has a wavelength separation solution that looks very scalable and can easily meet the most aggressive price point being sought in the WDM module market today. Arrayed-waveguide-grating (AWG) suppliers will struggle to play profitably at these per-channel price points. It is our perception that BaySpec could price well below this level at a very generous margin and would still have a lifecycle cost reduction story to pursue with customers. We are uncertain of the pricing strategy the company will choose, but in our own view, its time calls for the most aggressive option.Take the learning curve away from the alternatives. Put filters out of business in high-channel WDM module solutions. Eliminate AWGs as a potential platform solution and relegate it to an overpriced building block.
BaySpec is one situation only. We're talking about it because there are other companies in similar positions, and we think they too should go for the pricing choice that forces the market to consider their solution. There is a lot of talk these days that what is missing in the market today is a killer application that is leading consumers and businesses to demand and pay for expensive broadband solutions. That might be nice, but in our mind, three quarters of the problem is price. You cut system cost 75%, and you will enable carriers to deliver bandwidth to many more customers at a more affordable price. Deliver affordable bandwidth to a larger population of businesses and consumers, and they will find a way to use it. Some may even dream up a killer application.
"Dirt cheap" announcements like Xtera's characterization of its Nu-Wave DWDM system is only the beginning. Whether it engenders the carrier response they are hoping for remains to be seen. If it doesn't, other inexpensive bandwidth solutions will.
Kevin Slocum is a managing director and head of communications research at SoundView Technology Group (Greenwich, CT). He has more than 20 years of financial industry experience, including institutional equity research sales and analysis, and has been named to the Wall Street Journal's prestigious "Home Run Hitter" list two consecutive years. He can be reached at (203) 321-7200 or [email protected].
Readers pondering the opinions and analysis provided in this column are reminded that any investment involves risk. Lightwave and its parent company, PennWell Corp., are not responsible for the success or failure of investments made as the result of information provided in this column or anywhere else in the magazine.