Component ‘Cold War’

One of the more popular theories about why the Cold War ended when it did revolves around economics. The impasse between the United States and Soviet Union did not break because of intimidation or a lack of will, the thinking goes. After decades of brinkmanship, fist waving, and tanks in the streets, the Berlin Wall came down because the Soviet Union could no longer afford to keep it upright. In other words, the United States’ greater economic resources allowed it to keep the pressure on the Soviets until the latter’s comparatively limited resources could no longer keep up. The U.S. spent its foes into near bankruptcy.

I was reminded of this theory when listening to the “State of the Industry” panel at the OSA/Lightwave Executive Forum during OFC in March (see related story on the front page). While the executives from such companies as Avanex, Bookham, Finisar, Intel, and Opnext pretty much agreed that there were still too many companies chasing too few opportunities and that the current market dynamics were fairly dysfunctional, all appeared determined to stay their respective courses.

Such willingness to maintain course on what for most appears to be a very uncertain voyage is interesting in light of a presentation given earlier that day by John Ryan, founder of RHK. Among other interesting bits of research, Ryan presented a slide that showed companies ranked by sales volume (with breadth of product line a determining factor) along one axis and gross margins along the other. The graph showed that niche players enjoyed the best margins. Larger players-Ryan used JDS Uniphase and Finisar as examples-had what Ryan called “anemic” margins, while mid-sized companies (Bookham and Avanex were given as examples) had “dreadful” margins. In short, it appeared that margins-and perhaps profitability for those without adequate scale-were inversely proportional to the size of one’s product line.

Needless to say, this news isn’t good for companies that aren’t either really big or well-positioned in some niche. And that is where the Cold War analogy came to mind. On the one hand, you have a large company like JDS Uniphase, with significant cash resources. On the other, you have companies with aspirations to be like JDSU, a component superpower. However, such aspirations cost a lot of money to achieve. Perhaps in a growing market, these dreams might have a chance of coming true. But the current economic climate has created a stalemate not unlike that between the U.S. and defunct Soviet Union. Significant movement, particularly significant growth, is difficult to achieve in such a climate. Thus, the combatants hunker down and just burn cash maintaining their positions. As the Soviets had discovered, that can only go on for so long.

In this Cold War analogy, it’s easy to see JDS Uniphase as the United States and companies such as Bookham and Avanex as the economically disadvantaged. And lacking a reason to acquire either of these two pursuers, one can see JDSU resolutely sitting still, knowing that if the market dictates a wait-and-see approach, it can wait until Bookham and Avanex burn through their shorter cash reserves. True, these two companies may find additional cash somewhere, but such infusions would likely be little more than stopgaps.

Thus, staying the course for these companies and others like them appears to be a risky proposition in today’s times. They could attempt to scale upward, although one wonders how many of these companies have the funds to go on another acquisitions spree. Perhaps focusing on defendable niches within their current product portfolio and scaling downward might be helpful. While he said nothing about paring away product lines, Bookham chief executive Georgio Anania did indicate his company was placing its bet on a fab-based approach to differentiation and cost reduction. Anania said that where his company had differentiated products, it was enjoying good margins. It sounds like those product lines would be a good place to start to refocus.

Consolidation within the optical components space is long overdue. As we’ve discussed recently (see Lightwave, March 2005, “M&A divorce rate is on the rise,” front page), the mergers and acquisitions avenue has been blocked by the fact that few deals offer companies a chance to gain a profitable new asset. Perhaps when we see companies running out of funds and available for pennies on the dollar, deals will be struck. Until then, it looks like the Cold War will continue.