Enabling technologies: Optical manufacturing emerges and evolves
In the second installment of this two-part series, the authors discuss the lack of a photonics-enabling-technology sector in the industry and how its incorporation could aid the growth and profitability of the photonics market.
Eric Chen and Donald Lu
The photonics industry still lacks a well-distinguished capital equipment sector in its supply chain. We believe this photonics-enabling-technology (PET) sector is imperative for the photonics industry to maintain its growth and to become a highly profitable industry like the semiconductor industry.
Why don't we see a PET sector? Our research has identified inhibiting factors, both fundamental and transient, that perpetuate this deficiency in the photonics marketplace. We also propose a three-phase growth map for the photonics and PET industry. The current trough of the photonics industry could potentially be the genesis of a thriving PET sector.
Almost every photonics component has some manual processes in its production. Despite the high-technology nature of the products, manufacturing of optical components is most often compared to the shoe industry in terms of labor intensity, lack of automation, and lack of process optimization. Component assembly, fiber attachment (also called "pigtailing"), packaging, and testing are all notoriously known for their high labor intensities.
Another culprit is variability. In mature industries like silicon, the variance in performance parameters among different parts is well-understood and managed. Typically, a system is designed with this variance in mind, and enough error margin is built in to accommodate the idiosyncratic behavior of each part. In photonics, such system-level design practice is still immature, leaving the system performance dependent on the idiosyncrasies of each component. Variability on the component level, in part attributed to the manual labor involved in production, makes system-level assembly difficult to scale.
The situation is further exacerbated by the difficulty of codifying knowledge in this field and the resulting dependence on artistic experience. Many photonics manufacturing processes require certain skills that can only be obtained through practice and remain difficult to communicate. For example, an experienced coating engineer could easily increase the yield of thin-film coating by 100%, compared with a novice.
As a consequence, the yield and throughput are highly variable among photonics manufacturers, depending on processing technology. Processing technology is so important that many photonics companies treat it as a key competitive advantage. To safeguard the intellectual property in processing technology, vertical integration of manufacturing and processing equipment is a common scene in the photonics industry. JDS Uniphase, for example, has made a significant effort to develop new manufacturing technologies and automation solutions.
The downside of vertical integration is the lack of economies of scale. In other words, while JDS Uniphase would not sell its automation systems, a merchant automation provider may sell multiple systems to multiple customers, and thus achieve lower development cost per system. The current down cycle may effectively lessen the degree of vertical integration in the photonics industry. As a photonics company reevaluates its R&D programs to accommodate the reduced budget, it may eliminate some of these internal automation programs, which generate low return on investments.
Finally, the optical-component market lacks standards. For example, the form factor of thin-film dies varies among different vendors. This is widely recognized as one of the main inhibitors of manufacturing scalability throughout the supply chain, pertaining not only to the components but also to the modules and systems. Some of this variation stems from fundamental technological issues, while some of it is a reflection of the current economics in the early stage of the industry's maturity, which, we believe, can change rather dramatically over time.
Vertical integration, lack of standardization, high variability, and the proprietary nature of processing technology are all inhibiting factors to the growth of a merchant PET industry (see table). However, these factors appear to be transient and will diminish as the photonics industry matures. Observations to support this view include the following.
• Economic downturn usually lessens vertical integration for the sake of cost savings.
• We have heard numerous initiatives to implement standardization in photonics manufacturing. Interestingly, some of the proponents are PET companies rather than photonics companies. We believe this is a very positive sign of PET development.
• The recent layoffs and employee turnover may accelerate the diffusion of processing technology in the photonics industry.
In addition to the transient factors, the technology traits of the photonics industry are much more diversified than in the semiconductor industry. In Part 1 of this series, we summarized these differences as a lack of repeatable building blocks, a lack of uniform material base, and a lack of dominant manufacturing process (see WDM Solutions, September 2001, p. 35). These are some of the fundamental factors that fragment the PET industry and thus make it less attractive to investors. These fundamental inhibiting factors will probably remain with us until the arrival of a breakthrough technology such as some fashion of integrated optics.
THREE GROWTH PHASES
Until late 2000, the optical component market had to live with a rampant supply shortage. The backlog of optical systems was as long as six months in early 2000. To cope with the supply shortage, photonics companies embarked upon what we will refer to as the "brute-force" style of capacity expansion. This is characterized by rapid building of manufacturing plants, massive hiring of low-cost manufacturing personnel, and purchasing of basic, nonintegrated tools (see figure, p. 29).
Process-engineering innovations, automation, and standardization are largely absent from this type of expansion because all of these factors have to take lower priority to time-to-capacity. Time-to-capacity is such an essential competitive factor in the supply-constrained industry setting that manufacturers may choose to sidestep industrial engineering issues in favor of expediting time-to-capacity.
The brute-force phase of capacity expansion is rather unenlightening because it does not change the economics of the photonics industry, nor does it alter industry structure from the current state. Specifically, it does not foster the development of an organic supply chain, including a sophisticated supplier base. In short, brute-force capacity expansion retards the maturation of the sector. If a company is able to expand its capacity with relatively minimal capital investment and sell almost everything it makes at an attractive margin, why should the company worry about increasing productivity?
A major change in the photonics industry is occurring: the photonics industry has turned from being supply-constrained to being demand-driven during the first six months of 2001. For the first time in its young life, the photonics industry has to cope with a supply glut and a severe down cycle.
In the "brute-force" phase, manufacturing and process issues have held a relatively low priority, muting growth of the photonics infrastructure and providing opportunities only in isolated pockets. However, once supply catches up with demand (which is, after all, the goal of brute-force capacity expansion), the industry's dynamics will be fundamentally altered as a demand-driven scenario emerges. In this environment a successful company has to figure out its identity—whether it is primarily a technology leader or a cost leader. In our view, it will be difficult to remain in the middle. The technology-driven company will most likely continue to focus its resources on improving product performance and, to some extent, cannot afford to be distracted with manufacturing process issues. For commodity producers, on the other hand, cost and supply-chain management become overwhelmingly important concerns because pricing will probably approach marginal cost. After the move to regions with low-cost labor, the only other fundamentally viable approach to cost reduction is through improvements in manufacturing efficiency.
The rewards associated with an outsourced technology supply base will quickly materialize and power another phase of rapid growth in the photonics industry, although this time the growth will be dramatically different from that of the brute-force period. This subsequent growth phase will be characterized by rapid changes in the photonics business model:
- Rapid cost reduction, hence rapidly declining ASPs
- Improved manufacturing efficiency and scalability
- Reduced labor intensity combined with increased capital intensity
As photonics companies outsource manufacturing technologies, they will gradually migrate toward higher value-add activities, including deeper, more proprietary technologies; innovative component design; and module and system-level engineering
In our view, the PET industry will experience its true hypergrowth around this time. Its growth rate will be the compounded effect of two drivers: first, the gradual but growing trend toward outsourcing, and second, the growth of the photonics market itself, empowered by the newly developed merchant supply of enabling technologies and its attendant benefits. Realizing that the two industries, photonics and its suppliers, will be mutually stimulating, we label this part of the photonics and PET industries' life cycles as the "synergistic growth phase."
After the hypergrowth in the synergistic phase, we believe that the industry structure and dynamics between photonics companies and the PET players will likely stabilize. Technologies will standardize, manufacturing platforms will consolidate, and benefits of outsourcing will fully materialize.
At this point, we expect the PET market to start tracking the photonics industry in terms of growth. We will label this phase the "lockstep growth phase." To get a feeling for how the industries will behave during this period of time and beyond, one only needs to study the current state of the semiconductor capital equipment industry. The market for semiconductor equipment has largely tracked the semiconductor end markets, with 22% of semiconductor revenue spent on capital spending year in and year out for more than a decade.
AN EMERGING INDUSTRY
We believe the photonics industry has spent the majority of its short history in the brute-force mode, with only some embryonic activities in PET. Given the previous observation that the industry is transitioning from being undersupplied to having overcapacity, it is natural to postulate that the PET market may be entering the synergistic hypergrowth phase, making this the optimum time to identify investment opportunities in PET.
We observed some very encouraging signs at the recent National Fiber Optic Engineers Conference in Baltimore, MD. Ksaria, a startup developing automated fiber-preparation systems, attracted some of the heaviest traffic flow on the exhibition floor. Saggita is another startup working on an automated fiber-polishing system. Palomar Technology has integrated a fully automated production line for pick and place of components into module packages. Adept Technology and ATS Automation provide automation solutions for photonics manufacturing. Newport has added some material handling capability to its system, and Zygo is joining Newport to provide automated fiber alignment and welding stations. Automation in module assembly seems to be the overarching theme of the PET sector right now.
Our analysis indicates that automation in module assembly and testing has the largest market potential in PET, followed by semiconductor-based manufacturing technologies. Because photonics manufacturing is very fragmented and has traditionally imported from other technology areas, most players in the PET sector will have a heritage of serving other markets. As the photonics industry comes out of the current down cycle, we are confident that a prospering PET industry will emerge to propel the advancement of photonics technology.
Eric Chen is a senior analyst and Donald Lu is an associate analyst with J. P. Morgan Securities Inc., One Bush Street, San Francisco, CA 94104. Donald Lu can be reached at email@example.com.