More than meets the eye

When investment analysts attend a trade show, they have their own focus.

Given the timing of the National Fiber Optic Engineering Conference (NFOEC), we assume this issue of Lightwave took the opportunity to touch upon anything that was newsworthy at the show. Given the different focus of industry participants and investment professionals, we thought it might be useful this month to give our takeaway message from NFOEC.

We saw little on the announcement front that would alter our investment viewpoints. But we do believe the show was important in terms of the collective impression it provided and some of what we heard and saw from the startups.

Nortel was clearly the buzz of the show. Demand was the reason. The strength of Nortel's business was a topic of discussion everywhere. Truc Do, SoundView Technology Group's analyst on Nortel, heard of expectations next year for the company's optical systems group that were well ahead of Wall Street's projections. We viewed this as good news even for competing system vendors, because they are seeing second-source opportunities as Nortel customers hedge their bets in a demanding growth environment.

The story from the floor of the show was that Nortel was visiting component suppliers and pleading with them to believe its forecasts. Those forecasts also seemed consistent with the reports Truc Do had heard. Readers might be wondering about comments we have referenced, made in late August, suggesting some caution on the optical-component group due to valuation concerns. Well, the market took a good hit in the weeks that followed, but the group absorbed it well and reacted better than we believed it would.

So what did we expect from the optical component and systems companies in the wake of NFOEC? We believed the group would move up, at least through the third-quarter earnings report period. Business looked stronger than we had believed. As an indication of the strength, vendors were spreading their purchases over a wider list of suppliers to make their supply chain more certain.

The Federal Reserves' October meeting had come and gone without a rate hike. That was important to this group of stocks because valuations are so rich. When there is the threat of higher rates, high-valuation technology stocks are among the worst performers. But with no rate hike and only strong quarterly earnings ahead, we cast our recent caution aside and suggested that the group would trade up into strong third-quarter reports, in all likelihood achieving new highs.

First, we pointed to JDS Uniphase. The company has distanced itself from its competitors over the course of 1999, and it seems that only the large captive operations of Lucent Technologies, Nortel, and possibly Fujitsu are in a strong enough competitive position to hold the company in check. The stock had already posted a new high, yet we believe further gains are likely.

We also looked for SDL, E-TEK Dynamics, Corning, and Optical Coating Laboratory to push to higher highs by the time reporting for the group closed out with the JDS Uniphase results on Oct. 28. By the time you read this column, this will all be history and certainly your question will be, "What are we supposed to do now?" Professional investors have a job of outperforming their competitors. It isn't necessarily good enough to hold great stocks. They have to try to own more of them when they are doing their best and less of them in more challenging periods. You are only hearing from us once a month.That means there are a lot of days when we might say things to our customers that are important and never show up in this column. For Lightwave readers, we would advise you to stick with the long-term message--that the photonics area will be a very important source of investment profits over the next few years and most of the stocks in the area should be viewed as buy and holds.

We don't want to overlook the systems area. Certainly, the commentary on Nortel paints a compelling picture, and indeed SoundView has had its strongest rating on the shares throughout 1999. We are also very constructive on CIENA as we noted in last month's column, and nothing has changed on that front in the weeks since.

The NFOEC show was important in terms of the collective impression it provided and some of what we heard and saw from the ranks of the startups.

For us, Kestrel Solutions was the most interesting new system company at NFOEC. The company offered a completely different solution to the problem of getting cheaper bandwidth to the metropolitan access market. This is the residential/ small-to-medium-business market. The customers in this market have more pressing cost considerations when it comes to paying for high-bandwidth services than large enterprises. We expect Kestrel to focus its initial selling efforts on metropolitan access solutions.

The company's TalonMX uses a combination of technologies, including digital signal processing and optical frequency-division multiplexing (FDM), to deliver 10 Gbits/sec over a single wavelength for distances up to 70 km without the use of optical amplifiers. FDM is a technology that has been used by AT&T as far back as 1918 to put more than one voice channel on a copper pair. It was later employed in cable-TV and microwave applications. Kestrel has adapted the technology to make broadband services widely available at affordable prices in the metropolitan market.

The strength of Kestrel's transmission methodology is its bandwidth efficiency, scalability, protocol independence, flexibility, and cost. Many of its features directly address the challenges of making dense wavelength-division multiplexing (DWDM) more widely available in the metropolitan market. The technology has the added benefit of being compatible with DWDM meaning a carrier could eventually transport the TalonMX optical FDM channels across a wavelength on its long-haul DWDM network. Although Kestrel could pursue the broad metro DWDM market with its new system architecture, we believe its current efforts to gain Telecordia Technologies' osmine certification points to an early focus on the "metro access" market. The TalonMX is expected to be available in the first half of next year.

Meanwhile, Nanovation Technologies made its first appearance at an industry show and introduced a line of optical switches and tunable filters (which are available to select customers in single quantities for testing) that switch at nanosecond and sub-nanosecond rates, according to the company's preliminary data sheets. Nanovation is distinctive in its approach to manufacturing these devices in that they are micron scale planar structures etched in semiconductor material using processes similar to those used to manufacture electronic integrated circuits. This characteristic enables these devices to be used in high levels of integration and mass manufacturing. Nanovation's photonic device technologies can be integrated on a single semiconductor wafer as multi plexers, demultiplexers, add/ drop filters, high-speed switches, wave guide couplers, cross connect switches, signal processors, and optical interconnects.

Kevin Slocum is a managing director and communications research analyst for SoundView Technology Group (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 [email protected].

Robert Mandra is an associate in investment banking with SoundView Technology Group (Stamford, CT). Previously he was an optical engineer with MIT Lincoln Laboratory for nine years. He can be reached at (203) 462-7361 or rman [email protected].