Enabling technologies: The 'pick and shovel' of the photonics gold rush

Sept. 1, 2001
Eric Chen and Donald LuAlthough the market demand for photonics components and systems is potentially massive, the authors believe the current photonics business model is not sustainable because it lacks sufficient efficiency, focus, and economies of scale. This first article of a two-part series, looks at the market potential and the fragmented nature of photonics enabling technology. The photonics industry, which provides the building blocks for fiberoptic communications infrastructure, is destined to become a major force in the world economy. Despite the current slowdown in the communications market, the photonics industry is expected to resume high growth at 30% annually from 2002, according to a recent forecast by market research firm RHK. However, we believe the current photonics business model would not be able to support this expected high growth because it lacks sufficient efficiency, focus, and economies of scale. Contrasting the photonics supply chain to the infrastructure of Silicon Valley yields some useful insights.

We believe the current manufacturing processes employed in photonics-device manufacturing are so inefficient that they cannot support a profitable growth business over the long run. Take the industry leader, JDS Uniphase (JDSU), as a representative company, and assume that JDSU's manufacturing economics are typical for a photonics manufacturer. Each employee at JDSU generates roughly $110,000 of revenue per year. Considering the mix of low-cost labor employed by these companies, this can be a reasonably profitable business model. It suggests that approximately 125,000 people throughout the world are involved in making photonics communications products.

Now consider the future. RHK estimates the market for fiberoptic components will grow roughly 32% per year between 2000 and 2004. We will extend this forecast by assuming a 25% growth rate after 2004, and we will further assume that the component average selling price (ASP) will decrease 25% per year. Under this scenario the current model of employee productivity indicates that nearly 40 million people would be needed in the photonics business by the year 2011 (more than the entire population of Canada!) and each employee would generate only $4,100 of revenue a year. Clearly this is an unsustainable business model.

The only way to fix the model is to change one of the assumptions—either unit and ASP growth rates for devices, or the manufacturing economics. We believe the latter is more likely to change. Let us compare the revenue productivity in the photonics and semiconductor industries. In 1983 Intel generated $52,000 in revenue per employee. Sixteen years later in 1999, Intel had increased its revenue per worker to $420,000 (see Fig. 1). This increase was accomplished despite the fact that ASPs decreased 25% per year over the same period. The main driver for this remarkable improvement in productivity has been the relentless effort of the semiconductor industry to increase wafer size, to improve yield, and to implement automated manufacturing processes.

The photonics industry pales in comparison, a direct reflection of the highly labor-intensive process of photonics manufacturing. For an example drawn from the compound semiconductor industry, look at the difference between Vitesse and SDL (now JDS Uniphase). While Vitesse has almost doubled its revenue productivity in the last four years, achieving "Intel-like" numbers, SDL has seen basically flat revenue per employee. During this period, both companies greatly improved the yield and productivity of their III-V semiconductor operation. In addition, Vitesse also benefited from manufacturing outsourcing of CMOS products. What dragged down SDL was its expansion into the highly labor-intensive business of module assembly—not an uncommon problem in photonics manufacturing.

SHOVEL MAKERS PROFITOne may easily attribute the photonics industry's low productivity to some obvious reasons, including high manual-labor intensity, lack of repeatability, and low yield. A close examination of the supply chain, however, reveals yet another more out-of-the-box finding—the photonics industry lacks a specialized enabling technology sector.
In the semiconductor industry, device manufacturers rely heavily on the suppliers of equipment, design tools, and even pure intellectual properties. The equipment suppliers focus on improving the semiconductor processing and testing capabilities to enable Moore's law—doubling capacity every 18 months. This enabling technology sector offers economies of scale and standardization to the semiconductor industry. Together, the semiconductor and semiconductor capital equipment companies form the holistic semiconductor supply chain. For investors, there are Intel, which makes semiconductor devices, and Applied Materials, which provides semiconductor capital equipment. Both companies can be investment vehicles to cash in on the opportunities in semiconductors.

In the gold rush era, people said shovel makers pulled in the money. A hundred years later, one may find interesting similarities in today's technology business—enabling-technology companies are often better investment vehicles than the device makers that directly serve the end markets. Over the past 30 years, equipment vendors (shovel makers) were better investments than semiconductor device makers by nearly a factor of seven (see Fig. 2).

On the photonics side, the picture is far from clear. The technology supply chain remains under-developed. If JDS Uniphase is poised to become the Intel of photonics, where is the Applied Materials of photonics? What is the potential of this photonics enabling-technology (PET) industry? Analyzing these questions are important not just for companies such as ours that are always looking for great investment vehicles. It is also important for the overall health of the photonics industry.

HIGHLY FRAGMENTED Analogies between photonics manufacturing and the silicon industry can be helpful, but they can also be stretched too far. The most notable difference is that the photonics device sector is severely fragmented, with each market segment limited in size and, thus, unable to support its own specific enabling technologies. Three unifying principles underlie more than 90% of the worldwide semiconductor industry—core building blocks in the form of transistors/gates; a single material system, silicon; and a dominant manufacturing process, CMOS. No analogous items exist for the photonics industry. In our view, this fact has served to dampen the growth of a monolithic photonics-manufacturing sector and has caused the photonics industry to import tools from established neighbors (see table).

As a result, the PET industry is highly fragmented. There are four main types of front-end processes for making the majority of photonics components: semiconductors, encompassing both silicon and III-Vs, thin-film technology, microelectromechanical systems (MEMS), and micro-optics. Packaging and testing are the back-end sectors and require very different tool sets (see Fig. 3).

HOW BIG IS THE PIE?We have compiled our own industry model, broken into four distinct segments: semiconductors, MEMS, thin film, and module assembly and test. We have chosen to ignore the software, materials, and micro-optics segments because they are too embryonic or fragmented to quantify at this time. While the total market for photonics manufacturing tools is expected to reach almost $2.8 billion in 2004, the market suffers from fragmentation, with the largest segment being automated assembly and test, which is projected to become a $1.7 billion market (see Fig. 4). The runner-up, semiconductor tools, is expected to reach almost $925 million in 2004. Thin-film and MEMS tools are the fastest growing segments, but they make up a relatively small portion of the total market.

Next month, Part 2 of the series will discuss why the current trough in the photonics industry could be the genesis of a thriving and highly profitable photonics enabling technology industry.

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 protected].

Information herein is believed to be reliable, but J. P. Morgan Chase & Co. or its affiliates and/or subsidiaries (collectively JPMorgan) does not warrant its completeness or accuracy. Opinions and estimates constitute the authors' judgement and are subject to change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. J. P. Morgan may hold a position or act as a market-maker in the financial instruments of any issuer discussed herein or act as an advisor or lender to such issuer.

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