Correction doesn't herald oversupply

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While experience with the semiconductor industry may breed concerns, optical-component suppliers appear to know what's up.

By Kevin Slocum and Robert Mandra

One thing is certain about this year in photonics stocks in contrast to the moon shot of 1999. The volatility that you would normally expect from technology stocks finally has beset the group. With it has come the occasional bear story about supply catching up with demand. With that has come concerns that the major capacity additions mentioned by component manufacturers on every quarterly conference call will turn into a flood of excess components, crashing prices, and sinking profitability.

In early May, we hosted the third annual Wit SoundView Photonics Conference. With over 600 attendees, up from about 240 last year, we proved that the growth in investor interest in the area is keeping pace with industry revenue growth. But that is not why we bring up the conference. The real reason is something Tony Muller, chief financial officer of JDS Uniphase said on the subject of potential oversupply.

Professional investors learn lessons throughout their careers that help them avoid future pitfalls. In this case, most of the supply-demand fear stems from experiences with electronic companies, where we have had some tremendous boom and bust cycles over the years, inspiring com ments like, "The component suppliers will be the last guys to know." Basically what is being im plied is that the component suppliers are so far removed from the end customer that they cannot possibly know whether their computer-system customers are overly zealous about demand. If they are, the semiconductor component supplier will face a hiatus in demand, while the excess inventory their customers have stocked works its way out of the channel.

We in no way would go so far as to say that the optical-communications market doesn't face this sort of risk, but we will say that there are important differences between this market and the more mature computer and communications markets. That is what Muller pointed out. He touched on the much shorter list of customers and the absence of an independent distribution channel between optical-component suppliers and their system customers.

He also highlighted the nonstandard architectures of the various vendor solutions. There were a few other points, but the bottom line was that JDS felt pretty comfortable that it wasn't getting ready to lead its shareholders over a cliff with its capacity additions.

We were party to another conversation on this subject with one of our system contacts who sits in the position of being a significant buyer of optical components. Our call to the contact was to get a reaction to some new products we were learning about-but while we were at it, we decided to ask about how the company was doing with the component availability challenges. The reply was different than most investors might expect. Because of the early warnings of their key suppliers, this well-known company was managing its way through a problem that it expected to persist for some time. This situation points to a tight working relationship between component suppliers and their optical transport-system customers.

One of the reasons behind this relationship is the pace at which system vendors are adopting new system designs in the optical-communications market. It wasn't very long ago that Lucent Technologies was deploying eight-channel DWDM systems. Later this year, Nortel Networks will have customers running live traffic over its 160-channel Op tera system.

It doesn't stop at channel-count growth, either. We have ultra-long-haul, Raman amp lification, and 10-Gbit/sec transmission speeds going to 40 Gbits/sec. These functional changes create di versity in the optical-component market that demands good working relationships between supplier and customer. For now, these changes also make oversupply and commodity conditions the furthest thing from our minds.

Two things keep us up at night. The first is the question of whether carriers are overbuilding their network capabilities. Thus far, we feel there has been little evidence to support that threat. In truth, the whole idea of DWDM was to allow for the provisioning of capacity in a more linear manner that would approximate traffic growth. So far, from what we have seen, carriers seem to be burning through their channel capacity as quickly as they put it in. In addition to that, George Gawrys, division manager of transport network planning at AT&T, mentioned at the Wit SoundView conference that the cost per bit transported that his employer expected in 2001 will be a reality in 2000. That sort of performance out of DWDM systems is doing nothing but further encouraging carriers to adopt optical technologies more broadly.

The second worry is carrier product cycles or customer deployment cycles. Lucent has been one of the more visibly challenged op tical system vendors with it Wave Star OLS 400G platform. Ciena has had a number of customer deployment bumps along its road to success, affected first by the merger of MCI Com munications and WorldCom and later by the failure to close a customer they fully expected to land. We believe these experiences taught all sides something, but more missteps are lying in wait.

Right now, we are not hearing anything that is heightening our concerns about this ever-present risk.

Summer is here and optical component and system stocks are more volatile these days. Maybe we'll see more seesaw action in the group during the next couple of months, but at Wit SoundView, we remain very bullish about the prospects of this sector. As we write this column, seven companies in the group are on the firm's Focus List, up from four before the spring 2000 swoon, including Ciena, Corning, Finisar, Harmonic, JDS Uniphase, Nortel Networks, and SDL.

At Ciena, DWDM product sales remain robust, and ahead is the incremental revenue and profit opportunity from the company's CoreDirector. For Corning, the outstanding leverage of a fiber business running at full tilt is hard to ignore. Finisar is a company we haven't spoken of often, but as optical technology makes its way to the access markets, we believe Finisar will be well situated. Harmonic is substantially exposed to the adoption of wavelength-based services in hybrid fiber/coaxial networks. JDS Uniphase and Nortel probably require no explanation. Finally, SDL seems poised to move beyond its dependence on the erbium-doped fiber amplifier market. New-product cycles in lithium niobate modulators, Raman amplifiers, and network monitoring appear to be lifting management optimism to new heights.

Feedback at our conference and the outlooks presented by many of the companies when they reported first-quarter results further solidified our optimism that when second-quarter results are reported later this month, investors will be treated to an other outstanding group of quarterly reports.

We keep coming back to, "What's not to like?" The only consistent answer we come up with is valuation. Rich valuations are something with which we have become somewhat comfortable, because we have never witnessed a business environment quite as good as the one faced by the optical-communications companies. When that environment changes, so will our comfort level with the high valuations. For now, we are bullish on the group, despite the potential for summer doldrums for the market and the group.Th Acf6f4

Kevin Slocum is a managing director and communications research analyst for Wit SoundView (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 kslocum@witsoundview.com.Th Acf6f6

Robert Mandra is a principal in investment banking with Wit SoundView (Stamford, CT). Previously, he was an optical engineer with MIT Lincoln Laboratory for nine years. He can be reached at (203) 462-7361 or rmandra@witsoundview.com.

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