Trend scout rides the light with 'son of
Uniphase'
Money manager Phil Lamoreaux hit it big in the modern charge of the light
brigade by betting early on JDS Uniphase. Now, he sees a sparkling future
for optical-component maker New Focus.
By Jon D. Markman
Phil Lamoreaux prides himself on getting into big trends early. He first
bought a stake in fiber-optic components maker JDS Uniphase (JDSU,
news, msgs) for his hedge fund seven years ago. He paid the split-adjusted
equivalent of 25 cents a share, then held on as the stock rose steadily to the
point where JDSU is now the 53rd largest company in the world measured by
market capitalization.
Based in the picturesque marina town of
Sausalito, Calif., Lamoreaux largely passed on
Internet content stocks over the past few years
because he couldn’t understand their business
plans. But he hasn’t had any trouble putting his
money to work. Almost all has gone into a few obscure optical-networking
equipment firms that he believes have the management, product mix, funding
and production capacity to become his next 500-bagger. “You have to have
some money in front of a megatrend,” he says.
In my first column on how pioneering money managers make momentum
trends happen (“Trend scouts: Finding the next stocks to sizzle“), I noted
that taking advantage of growth tsunamis requires both patience and
conviction. Lamoreaux has shown both with his latest top pick in the space
-- an optical components maker called New Focus (NUFO, news, msgs).
But before getting specific, let’s zoom out for his big view.
Bigger than PCs or wireless
Lamoreaux believes that neither the public nor the major institutional
investors have yet fully grasped how immensely, insanely, unbelievably huge
the optical-networking business is going to become. In his view, we’re only
about five years into an industry that will ultimately be much bigger than PCs
or wireless; an industry where it’s still the investment equivalent of 1986,
when people already knew a few big names like Intel (INTC, news, msgs)
and Microsoft (MSFT, news, msgs), but had not yet heard of tiny Dell
Computer (DELL, news, msgs) or Cisco Systems (CSCO, news, msgs).
“Great wealth was made in those businesses -- but in time, the fortunes in
optical networking will swallow them whole,” he says.
Crazy talk? Not to Robert M. MacLellan, director of business analysis at
telecom consultancy RHK Technology in Toronto. He believes the sudden
emergence of optical-networking companies has caught investors by surprise
because, five years ago, few expected that the average person would get
access to the Internet and make it a mass medium in record time. As a
result, major telephone carriers have been forced to amp up their capital
expenditures for high-end networking gear at light speed --yanking money
away from voice-networking budgets and spending every spare billion on fiber
and optical circuitry that carries data faster, more reliably and at a lower cost
than competitors.
“Just do the math,” says MacLellan. In 1999, he notes, Internet traffic
amounted to 350,000 terabytes (trillion bytes) a month. By the end of 2003,
with more people worldwide coming online and everyone finding vastly more
compelling, interactive content at vastly faster speeds, he expects traffic to
grow by 500 to 1,000 times, to at least 16 million terabytes per month. “If
that sounds too high, just consider that the one thing we’ve consistently
underforecast is bandwidth demand,” he says.
MacLellan says that new carriers like Global Crossing (GBLX, news, msgs)
and Qwest (Q, news, msgs) have spent the last couple of years digging
holes in the ground and buying fiber. Now they’re taking the same funds that
were once aimed at paying for backhoes – called “poles and holes” in the biz
-- and are instead purchasing terminal equipment from new systems vendors
like Corvis (CORV, news, msgs), Avici Systems (AVCI, news, msgs) and
privately held Tellium. Likewise, incumbent carriers like WorldCom (WCOM,
news, msgs) and AT&T (T, news, msgs) are reapportioning the capital
expenditures that they formerly aimed at electronic voice-switching
equipment toward buying optical data-switching equipment. This explains
why optical sales can rise even as overall spending for capital equipment
flattens or slows. Today, optics account for 10% of telecom capital
expenditures, but are expected to climb to 50% in four to five years,
according to a recent Merrill Lynch analysis.
Focus on New Focus
Enter companies like New Focus, which Lamoreaux calls “son of Uniphase.”
Its valuation traces the recent history of risk capital in Silicon Valley. In
1998, you could have bought a 10% stake in the firm for $4.5 million. A year
later, much smaller stakes were sold for $20 million and $30 million. The firm
went public at $20 a share on May 18 this year, giving it a $1.1 billion market
cap, then shot to $165 in the euphoria of June. Now it's settled back to
around $85 – a price Lamoreaux (lead investor in that first round, at $1 a
share) still considers a bargain. “I don’t see why it shouldn’t go up 10 times
from here over the next half a decade,” he says.
The reason: management and breadth of innovative products. He calls the
firms’ executives “superb,” and who’s going to argue? The founder and
chairman is Milton Chang, a physicist who was a seed investor in Uniphase
and built another optical firm, Newport (NEWP, news, msgs), which has
seen its stock rise 2,950% in the past year. “Milton knows all the deans of
all the top engineering and physics schools and gets the pick of the litter of
the new PhDs,” Lamoreaux says..
Based in Santa Clara, Calif., the company started by inventing advanced
“active” components, such as tunable lasers, and has since moved into
“passive” components as well. One of its top products in that category is
something called a polarization beam combiner, which solves a key problem
for customers like Corvis by quadrupling the capacity of laser beams to travel
long distances on less power.
Sales in the most recent quarter were $14.5 million, and chief executive Ken
Westrick said that he has so far not seen any slowdown in the company's
growth this quarter. He affirmed he's comfortable with analyst forecasts for
growth north of 100% for at least the next two years. “Our current customers
are increasing orders of current products, and we are seeing them in the
process of qualifying additional new products; we anticipate extremely strong
growth for the foreseeable future,” he said. “You can’t underestimate the
explosive demand for bandwidth -- it’s like an addiction. As you give people
more, they want more. I think we are years away from saturation.”
Feeding that addiction with a broadening mix of components and
subsystems that make beams of photons bear more data and travel farther,
he said the firm expects to use a low-cost, high-volume strategy to be
profitable in the first half of 2002. Until then, it has $440 million from a
secondary offering in August with which to rapidly expand production
capacity both in California and China.
Investment risks are about execution, component constraints, the capital
markets’ fickle affections and the extreme difficulty of hiring qualified
personnel to build the stuff properly at high speed. MacLellan, the telecom
analyst, noted that the manufacturing of components “is hard -- it’s manually
intensive, it’s more of a craft business today than anything else, and at some
vendors the actual manufacturing personnel are Ph.D.s.”
Those factors, plus a high valuation in traditional terms, make New Focus a
risky bet today. But after the current equity conflagration runs its course --
and after the firm gets a chance to show its execution capabilities over the
next couple of quarters -- it seems that these shares might well come to
deserve a core position in growth investors’ portfolios. Conrad Leifur,
technology analyst at U.S. Bancorp Piper Jaffray, said he believes the
company could be clocking $1 billion in revenue annually by 2004, with
pretax net margins similar to JDS Uniphase and in the 30% range. His
12-month target for the stock is $160.
Fine print
To learn more about New Focus and its wave-division multiplexing products,
visit its Web site. Budding entrepreneurs should check the Founder’s Corner
page, where Chang has posted a 12-part article on starting and managing
your own company....A new investment-banking firm, Epoch Partners, has
been publishing excellent research reports online for the public at its Web
site. Read the one on New Focus (requires free registration)....To learn more
about the fastest-growing sectors of telecommunications, check out reports
from MacLellan’s firm at the RHK Web site....Another place to keep up on
developments in the industry is Network World Fusion, a news and
community site for carriers and suppliers....And don’t forget the best of all:
Lightreading.com.http://moneycentral.msn.com/articles/invest/models/5768.asp |
