The bandwagon keeps rolling

March 1, 2000

By Kevin Slocum and Robert Mandra

Since we last wrote, SoundView returned to strong buy ratings on the shares of three component companies that we follow. We continue to hear about the incredible strength in demand for transport systems and had to discard our concern about valuations. Business appears so strong that we figured we'd better stay focused on fundamentals and let someone else worry about valuation. We had also been picking up on expected unit-shipment requirements from their system-vendor customers that didn't seem to be reflected in the financial community's estimates for the companies.

Our clients always press us on the valuation question, though, and one thing we discussed with them helped put things in better perspective, so maybe it's worth repeating. First, we want to recap where 1999 ended up in the photonics sector because when we wrote our 2000 outlook column, the final figures were not in. Remember that tsunami we mentioned? Well, the SoundView Photonics Index rose 444% last year compared to the overall SoundView Technology Index at 130%. The S&P 500 Index managed to tack on 19.5%, and I think we all heard about the Nasdaq Composite Index up over 80%. Not bad.

So we have this investor dilemma: Faced with a 2000 photonics business environment that appears extraordinarily healthy, can they reach a comfortable conclusion that new buyers will pay still higher prices for the shares after the phenomenal moves of 1999? After all, the half-dozen public optical-component companies that SoundView actively follows ended the year with over $100 billion in market capitalization on combined sales of about $2 billion. That compares to SoundView's semiconductor coverage, with $463 billion of market capitalization and $77 billion of sales.

In trying to provide some comfort, we suggested that in five years the six companies could produce nearly $25 billion in optical-component sales. That would put the optical-component industry on a path of generating in less than 10 years the same $77 billion that it took over 20 years for our semiconductor coverage to produce. The story on the optical system side of things is no easier when it comes to valuation, but the ramp-up of revenue for these companies is equally phenomenal.

We joked at the time about multiple of total available market (MTAM) as the only new valuation metric we could come up with. Makes sense right? First, we abandon price-earning ratios and move to multiples of sales. Next, we abandon multiple of sales for MTAM. But we have looked at it a little more closely since that first joking mention, and maybe it's not such a joke. Many individuals and company executives out there think we stock market people are nuts and can't fathom how we justify the ups and downs of stocks and the stock market itself. Having been involved with the market for many years, we have become pretty respectful of the stock market as a pricing mechanism. Wasn't Cisco always an expensive stock where if you let the price get to you, you would never have owned the shares? It is only one of dozens of examples.

So let's look closer at MTAM. The six component companies we cover were trading at five times the current forecast for the total available market in 2003. If you look at the semiconductor group we noted, it can probably be expected to grow at 15% per year over that four-year timeframe, which would push sales to $135 billion. That means the SoundView semiconductor coverage universe is trading at about 3.4 times the MTAM for 2003 in contrast to the five multiple we mentioned for optical components. Over that same period, we expect our optical-component coverage to grow at over three times the rate of the electronics group. So are the optical-component shares we cover overvalued? Or does the investment community have a legitimate understanding of where this group is headed, and as long as the companies execute, the shares will plow ahead?

We believe the answer is the latter, and therefore our attitude is that if the bears give you a chance to buy into weakness because of occasional bouts of fear of higher rates or something of that ilk, we would be inclined to take advantage. One caveat is that not all stories in this space are created equal, even though they were in 1999. There will be winners and losers, companies that are better positioned than others, and companies that are better managed.

For years, carriers have, on occasion, gotten warrants or even shares in startup companies in exchange for their relationship that might enable the vendor's product-development effort and even its existence. Never before has it meant as much as it has come to mean in the past year or so. Williams Communications was highly visible in this fashion in 1999 with its stake in Sycamore Networks. We all know what happened with the IPO and the subsequent $400 million order from Williams. Everyone has their own views about the appropriateness of these type of relationships, but in essence, it is a risk/reward sharing transaction that serves to create a common interest and focus for both parties that can enhance the chances for success of the program. That doesn't seem like such a bad thing to us.

The visibility comes at an interesting time for SoundView. Since SoundView's founding as a division of Gartner Group 20 years ago, we have exclusively focused on technology. Historically, we looked at the communications-services area, not as technology, but rather as a business whose success was determined more by governmental decisions and rate relief than technology. In mid-1998, we started to crack a bit when we hired an analyst to bring up coverage of the wireless services market. Our thinking was that technology was going to be an important determinant of the success of wireless services, and therefore it was time for SoundView to cover the companies.

During the course of last year, we have felt that in some ways we were missing the boat in not applying the same thinking to the rest of the carrier markets. As more situations like Williams and Sycamore transpired, the feeling continued to nag us. The verdict is in. We are definitely missing out. What tipped the scales were a number of inquiries from significant carriers indicating to us that they needed to know as early as possible what was coming down the pike on the new technology front.

Their interests, although significantly focused on systems, included an understanding of what was occurring on the component front. Will attitudes change when the magnitude of the profit opportunity begins to look less certain? We don't think so. We believe this growing trend has more to do with how critical technology has become to the success of carrier services as well as the new pace of growth they now have to learn to live with. It may be something else that we can take some comfort from. We don't have technology seeking a market. We have a market seeking better solutions as soon as they can get a hold of them.
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].