I hope I'm not wearing any of you out.
From Red Herring;
Fiber optics takes the
spotlight
By Vanessa Richardson
Redherring.com
September 3, 1999
Now it's official: fiber optics is white-hot. Cisco
Systems (Nasdaq: CSCO) announced last week it
was buying two privately held networking companies
that specialize in fiber-optic systems -- Cerent and
Monterey Systems -- for a combined $7.4 billion. The
$6.9 billion laid out for Cerent was the most ever paid
for a tech startup.
"Cisco put the seal of approval on
the fiber-optics industry and the
valuations that the individual
companies are getting," says
Kevin Slocum, analyst for the
SoundView Technology Group.
That particularly applies to the
component makers, companies
that sell the nuts and bolts -- or, in
this case, the lasers and multiplexors -- to companies
(like Cisco) that design the network systems, which
then in turn sell the systems to phone and data carriers
to install on their networks.
Last Thursday, the Cisco announcement sent the
prices of the three major component makers soaring.
They've since fallen a bit -- JDS Uniphase (Nasdaq:
JDSU), the No. 1 parts maker, closed Wednesday at
$110; smaller supplier SDL (Nasdaq: SDLI) closed at
$81.19; and E-Tek Dynamics (Nasdaq: ETEK), after
dropping lower, closed back up at $60.75 -- and offer
the opportunity to buy into the infrastructure.
Not that they're bargains at these
prices, though. Based on
estimated year 2000 earnings,
JDS Uniphase trades at a
price/earnings ratio of 100, E-Tek
at 96, and SDL at 75. Because of
that, some analysts have
downgraded their ratings from
Strong Buy to Buy or Hold since
the Cisco deal went through,
based on pricey valuations.
Other analysts and fund managers think the
nuts-and-bolts makers are still worth the price. "Lucent
[NYSE: LU], Nortel [NYSE: NT] -- all the system
suppliers get their basic equipment from just a handful
of companies," says SG Cowen Securities analyst Jim
Kedersha. "In short, they need these guys. They can't
go anywhere else."
THE CHOICE IS CLEAR
Fiber-optic technology has been around since the late
1980s, primarily in long-distance telephone system
backbones. It has become a hot item now for both
phone and corporate networks because of growing
demand for bigger bandwidth. And fiber has great
headroom. The laser light that carries data through
fiber-optic glass can be split into different colors, or
wavelengths, each of which carries a discrete data
channel. Better yet, transmission facilities for new
wavelengths can be retrofitted onto existing plants that
connect to fiber already in the ground, which makes it
the easiest way to increase bandwidth.
Wall Street estimates for annual growth in the use of
fiber optics settle around 30 to 40 percent. In its
acquisition announcement, Cisco estimates that the
market will hit $17 billion in 2002. Currently, fiber
optics is most widely used for long-haul
telecommunications (e.g., phone calls from Los
Angeles to New York) and for overseas cable laid
underwater, but it has found a new use in metropolitan
areas for cable TV and corporate intranets -- AT&T,
for example, is using fiber optics for cable
transmission.
For all these uses, component makers supply the
lasers, the chips, the amplifiers, and various other
gadgets needed to send the light skipping down the
wire. "If you buy into the fact that Moore's Law
applies to fiber optics and that demand is doubling
every six months, these companies are worth buying
into," says Philip Fine, a portfolio manager for Loomis
Sayles & Company, which holds JDS Uniphase and
SDL in its Aggressive Growth fund and private
investments. "Cisco is the best large-cap play on
infrastructure, but components stocks are another way
to profit from it."
THE LEADING LIGHT
With the June 30 merger of JDS Fitel of Ottawa and
Uniphase of San Jose, JDS Uniphase became the top
components supplier. Mr. Fine and comanagers
bought into JDS Fitel three years ago after hearing
CEO Kevin Kalkhoven's vision of the fiber-optics
market evolving from the long-haul market to the
undersea cable market.
Mr. Kalkhoven's plan was to strategically acquire
smaller component companies around the globe, as
well as to buy component divisions from large
corporations eager to divest -- such as IBM (NYSE:
IBM) and Philips Electronics (NYSE: PHG). With
such acquisitions, Mr. Fine says, "instead of giving a
system vendor just a plain chip, JDS Uniphase can
give it a fiber casing and can call it a module, so it's
moving up the food chain from just making
components to making modules and subsystems."
For the 1999 fiscal year ended June 30, 1999, JDS
Uniphase reported pro forma sales of $587.9 million
and net income of $124.9 million, or $1.47 per diluted
share. For the fourth quarter ended June 30, 1999,
Uniphase Corporation separately reported sales of
$87.1 million, up 68 percent from the $51.8 million
reported in the same period of fiscal 1998. Net sales
for the fiscal year ended June 30, 1999, were $282.8
million, 53 percent above the $185.2 million for fiscal
1998. For the fiscal year ended May 31, 1999, JDS
Fitel reported sales of $305.7 million, up 101 percent
from the $162.2 million in 1998. Net income for the
year was $66.4 million, a 108 percent increase over
net income of $34.0 million in 1998.
IN THE SHADOWS
San Jose-based SDL's product line isn't as broad, but
the company argues that it has better technology and
more powerful chips. For example, it came up with the
module packaging idea first -- but was slower to move
than JDS Uniphase.
SDL's bread and butter is pump laser modules, which
reamplify optical signals moving down the cable so
they maintain their strength and integrity. It's a
breakthrough product that popularized the use of fiber
optics undersea. (Currently, the undersea market
makes up only 10 to 15 percent of total revenues, but
that percentage is expected to grow rapidly.) The
company has a four-year deal with undersea cable
giant Alcatel (NYSE: ALA) and is in the process of
firming up deals with Tyco International and Japanese
vendor KDD. The company is also expected to benefit
from the state-of-the-art 80-channel wave-division
multiplexor that Lucent is planning to bring out later this
year, since SDL provided the pump laser modules for
it.
For the first half of 1999 ended June 30, SDL
revenues were $80.8 million, compared to $55.3
million for the same time period in 1998. Net income
was $8.07 million, or 18 cents per diluted share,
representing a 158 percent increase from a net income
of $3.12 million, or nine cents per diluted share, for the
same period in 1998.
When E-Tek, also based in San Jose, had its IPO in
December, its shares more than doubled from the $12
opening price. The company has been around since
1993, originally founded as an R&D firm for the U.S.
Department of Defense and NASA. For the 1999
fiscal year ended June 30, revenues were $172.7
million, 61 percent more than the $106.9 million
earned in 1998. Net income was $46 million, or 45
cents per diluted share, representing a 53 percent
increase from a net income of $30.1 million, or 33
cents per diluted share, for the same period in 1998.
A LIGHT GRIP
These three vendors -- JDS Uniphase, SDL, and
E-Tek -- own their market now and for the
foreseeable future. "All of them can breathe easier than
in other industries because barriers to entry are so high
here," says Hoefer & Arnett analyst Colin Higgins.
And unlike the semiconductor industry, pricing stays
stable because of capacity constraints. "Prices come
down, true, but the curve is less steep because its
customers have nowhere else to go," says Mr. Fine of
Loomis Sayles. "These guys see operating margins
north of 30 percent and profit margins north of 50
percent."
Yet it is difficult for component companies to keep up
with demand. While competition is minimal, the
component business is known for long design cycles,
short product cycles, and the complex, demanding
process of ensuring that the products work without
flaw for long periods of time. That requires a devoted
engineering team, which can be hard to recruit and
retain. "JDS Uniphase has its main office in Ottawa,
which is a pretty small place. How are they going to
keep luring people there?" says one analyst, who
asked not to be named. "So far, they've met the
challenge, although I don't fully understand how."
And E-Tek's catalog is not quite deep enough, says
another analyst: "It's diverse, but they need to ramp up
their breadth."
WHAT'S NEXT?
The big trick is predicting where companies in this
market are heading. JDS Fitel led the way in
acquisitions with Uniphase, and it is expected to buy
more properties. "JDS acts like Cisco in that it picks
up tech companies that the industry doesn't really think
about and pays more for it than expected, but it
hedges its bets by making certain it's leading the way in
the direction where technology is moving," says Mr.
Fine. Analysts think JDS Uniphase will next approach
equipment vendors who also make their own
components and propose to buy the component
divisions; Nortel is expected to top the list.
After that? Rumors are rampant. Because of the JDS
Uniphase merger, E-Tek and SDL are often talked
about as a natural merger, although SDL has publicly
said it isn't interested in a blockbuster deal, but rather
in making smaller, strategic acquisitions. One company
in the crosshairs: Harmonic (Nasdaq: HLIT), based in
Santa Rosa, California, which makes optical transport
"return path" solutions; it has seen its stock price shoot
up 475 percent from near $20 to $115 since January.
Then there's the possibility that a larger
component/equipment maker, such as Corning
(NYSE: GLW) or Nortel, could be eyeing one of the
component makers. One analyst we contacted couldn't
talk because he was called away by one of the
companies mentioned in this article for a "last-minute,
shadowy meeting," which other analysts take to mean
that another optical deal will soon see the light of day.
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