The Great Optical Capacity Crunch of 2002
Alan Luber
Monday, October 15, 2001
Optical glut? That was then. This is tomorrow. Trust Alan -- a major crunch is coming.
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Articles about cuts in telecom capital spending continue to make the headlines. For example, Worldcom's latest projection for 2002 capital expenditures is 27% lower than this year and 35% lower than last year's figure. That's right -- a 35% reduction in capital expenditures in two years!
And still, I tell you, even with capex cuts of 35% over two years, there will be an optical components capacity crunch by mid 2002.
How can that possibly be?
The reason is simple -- while companies at the top of the supply chain have been cutting expenditures by up to 35% over two years, companies at the lower end of the supply chain have cut capacity by 50% to 60% -- and are still cutting in order to survive. For example, so far this year JDS Uniphase has laid of 55% of its employees and eliminated two million square feet of office and factory space.
It's easy to understand why the capacity cuts have been deeper at the lower levels of the supply chain. Faced with a combination of slower demand and an inventory build up throughout the supply chain, companies like JDSU have had to slash capacity 50% to 60% to weather the storm and survive. For these companies, demand went to near zero for an extended period of time.
High inventory levels have obscured the inevitable capacity crunch problem for the past nine months, and will likely obscure the problem for another six months. A recent report from Merrill Lynch concludes that there is still $4 billion dollars of excess optical component inventories in the supply chain, and that will take until the first quarter of 2001 to work these inventories down to normal levels.
Because of this, the report argues, revenues from optical component companies in Q4 will understate actual consumption of optical components by 37%. The same report argues that the market for optical components will grow modestly by 7% next year, and 24% in 2003, as carrier spending bottoms out and starts to pick up. So the net increase in demand, once inventories are driven to normal levels, will likely be 44% from current levels in 2002 and 61% from current levels in 2003.
Now let's assume that by reducing capacity by 60%, JDSU has balanced its capacity to reflect the actual new orders it is receiving. That is, let's assume that supply (capacity) is now in balance with demand (new orders). This seems like a reasonable assumption -- I doubt very much that at this point JDSU has thousands of people standing around waiting for the inevitable upturn in business that will come once the $4 billion dollar inventory stockpile has been consumed. The new orders JDSU is currently receiving most certainly reflects demand that for one reason or another cannot be satisfied from the $4 billion dollars in excess inventories of optical components. Most of these orders are probably for new components that were not part of the inventory bubble.
Now consider this: what do you think is going to happen next year when the inventory in the supply chain is finally exhausted and JDSU suddenly -- and I do mean suddenly -- sees a net 44% increase in demand? What does C-R-U-N-C-H spell?
Once the capacity problem is exposed, three things will happen:
Prices will firm up and margins will increase for component suppliers, leading to another boom cycle.
Optical component companies will be very skeptical about adding capacity at first, causing the capacity crunch to last well into 2003. Ah, yes, I can see Jozef Straus sitting in his office, his beret slightly askew, wagging his finger, saying, "Fool me once, shame on you. Fool me twice, shame on me."
Lead times will increase and companies will begin double and triple ordering. This will send false demand signals down the supply chain, causing companies to (eventually) add capacity to satisfy phantom demand, ultimately leading to another bust cycle in 2004 or 2005 -- but that's years away, so let's not worry about that just yet.
Its ridiculous to think that these stocks will reclaim their highs of 2000 anytime soon, if ever. It is important to remember that the growth projections in 2002 and 2003 represent growth from current revenue levels, which are significantly depressed from the record levels of 2000. But it is not ridiculous to think in terms of record margins next year brought on by a capacity crunch. And it is not ridiculous to invest in what will once again become a capacity constrained level of the supply chain.
The capacity crunch is inevitable, and it amazes me that most people just don't see it. People are as blind to the understated demand this year, as reflected by the actual consumption of optical components, as they were to the overstated demand last year, as reflected by the double and triple ordering that took place.
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