It’s been interesting to work on JDSU when infrastructure and optical networking are taking such a bath. The whole exercise brought home the value of the long time horizon of GG.
Because the dynamics within optical networking and consequently for the merchant vendors are changing so fast, I added two sections to the Project Network format: an overview of optical networking and of the component supplier market. I’m mindful that this runs counter to UF’s admonition about the benefits of brevity. But JDSU’s network effects are tied closely to structural shifts in optical networking and among the component makers. And without a Hunt report for backup, some informational backfill seemed important to me. For those familiar (or bored) with JDSU or optical networking, just click past.
I want to thank Pat Mudge. The research and resources supplied were incredible. Also, Mtnlady has not been around so any arrows should be directed my way.
Project Network: Report on JDSU
Paul Krugman argues in The Self-Organizing Economy that network effects don’t necessarily create expanding returns. Two laws govern network effects, but they pull in opposite directions:
DeLong’s Law: In building a network, valuable connections tend to be made first. (diminishing returns)
Metcalfe’s Law: The value of a network grows exponentially as new members join arithmetically. (increasing returns)
Value proposition:
 Whether JDSU’s mission--partnering with customers to increase their competitive advantage--and its execution by management tip the scale in favor of Metcalfe’s Law for the company. Do JDSU’s efficiencies, performance, and scale create lower costs, higher quality, greater functionality and reliability for its customers, thereby increasing customer leverage? Do JDSU’s broad portfolio of products and execution raise switching costs and give it an edge with customers? Is that edge sustainable?
 Whether the optics sector is evolving so that barriers to entry and switching costs increase. Where are we in the TALC and are trends in photonics likely to produce greater concentration with a prolonged CAP for the dominant players and increased network effects?
Summary:
 The optics market is in its infancy. All elements—primitive cottage-industry manufacturing processes, the absence of any “standard,” etc.—indicate the sector is in the “second inning of an extra-innings game.”
 ULH (ultra-long haul) in the US and Europe will continue to experience rapid growth. Spending at the edge (with its submarkets of dedicated access and shared access) and in metro will outstrip cap ex needed at the backbone, however, with metro entering the tornado in 2 to 3 years. New markets (like China, which JDSU tapped into with its acquisition of Etek) and Asia will grow exponentially as more and more products are qualified by customers. Submarine systems connecting these new and existing markets also appear poised for sharp increases.
 Elasticity of bandwidth creates network effects. For every 1% drop in price, it is estimated, there is a 5% increase in bandwidth usage, primarily in packet-switched data traffic. Simultaneously, however, carriers are experiencing declines in revenues per minute for voice as a result of post-deregulation competition. To maintain or accelerate current growth rates, JDSU must be able to deliver technologically advanced modules that increase both the effectiveness and efficiency of its customers’ (the systems companies) solutions, enabling them, in turn, to pass along decreased costs to their customers (the carriers), while opening up new revenue sources for the carriers.
 Networks will move away from point-to-point architecture to mesh architecture, increasing capacity, distances, speed, and manageability while decreasing costs. This movement will raise the ante for component makers. They will have to supply all the technological building blocks for their customers’ end-to-end solutions with emphasis on interoperability, reliability, high speed and capacity, and low costs. Next Generation (NG) networks will require smarter traffic cops, and software will play an increasingly important role.
 Physical properties of optics at high speed will hasten movement toward more all-optical solutions without OEO (optical-electrical-optical) conversion, eliminating expensive equipment to convert light into electrical impulses for part of light’s travel on a network. While optical computing is still “science fiction,” hybrid solutions like MEMs (microelectro-mechanical) switches will temporarily meet the need for additional “intelligence” within the system and allow for remote control, large-scale switching, and bandwidth allocation on demand, all necessary for more efficient and economic traffic control. The key to an intelligent optical network will be an optical or sophisticated hybrid router.
 As a result of the higher functionalities and complexities of NG systems, solutions at the module and subassembly levels of suppliers like JDSU will increasingly be “designed into” the systems, raising both the barriers to entry and the switching costs for new entrants and magnifying the network effects for JDSU.
 Time to market will continue to be a critical factor as carriers seek to capture customers/market share and decrease their cost structures. To shorten time to market, systems vendors will accelerate pressures on suppliers like JDSU toward modules and subassemblies with the logical next step being to tie multiple modules together on a single optical integrated circuit chip (OICs).
 Competition will be fierce and any misstep harshly punished by customers. “Captive” optics components divisions will be spun off, and aggregation by acquisition will continue along with in-house development as dual modes of capturing cutting-edge technology. Non-mission critical aspects of the component/ module business will be outsourced, with management attention focused on increasing productivity and on r&d to meet customer needs and timetables.
 The merchant vendor market will concentrate in the direction of two dominant players. Systems providers refuse to be captive of one vendor. At the same time, they don’t want the trouble or time it takes to qualify vendors #3, #4, or #5.
 JDSU’s ability to capture network effects depends on sustained growth in the optical networks, but also critically on its continued execution—in terms of productivity gains and technological solutions. Today among the component suppliers JDSU has by far the broadest portfolio of products, enabling it to put together modules and subassemblies in each of the four areas of optical systems: transmission, DWDM, amplification, and switching. Were it to lose its edge in any one of these, it would seriously hamper its ability to “partner” with its customers in developing end-to-end solutions. If, however, JDSU develops OICs on which its NG customers can standardize their systems design, JDSU will experience increasing network effects, its products effectively being designed into the systems from the get-go.
I. Basic Facts: Financial
JDSU’s financial statements are complex. It uses purchase, rather than pooling, accounting, which makes year-over-year or sequential comparisons difficult, given its acquisition of or merger with 11 other companies (although it does provide pro-forma statements as supplements to the financials).
Q1'01/ Q4'00/ change
Gross margin: 51.0%/ 50.2%/ 2%
Net margin: 22.5%/ 21.8%/ 3%
Flow Ratio: 1.73/ 1.33/ 30%
Cash King
Margin: (20%)/ (2%)/ NM
Revenue Growth: 1-year 336% 3-year 133% 5-year 102%
Last quarter: JDSU—171% SDLI—208%
QOQ: Q1 ’01 $787m; Q4 ’00 $524m; change 50%
Book to Bill: 1+ (“solidly above 1”; 10/26/00 quarterly earning conference call)
Cash Minus Debt: $1,114.3m-$56.1m=$1,058.2. JDSU has debt other than the $41 million assumed with the Etek acquisition and $15.6m in secured term loans.
Convertible Debt as Percentage of Total Debt: none
ROIC: 60.4% (FY ended 6/30/00)
WACC: 17.5% (Average weighted rate on debt, 6.73%; beta, 2.09; market return, average S&P, 11.21%)
Market Cap: 59,134.53 (millions)
Markets and Share: 50% in most components; 80% (with SDLI merger) in critical components like pump lasers
Competitors’ Markets and Share: (est.), no single vendor has more than 20% when Sonet is excluded
Notes:
Decline in gross profit as a percentage of net sales from 1999 to 2000 reflects the impact of purchase accounting adjustments for inventory of Epitaxx, Sifam, Ocli and Cronos. Improvement 1999/1998 from 48% to 51% and Q1 ‘00/Q4 ’01 from 50.2% to 51% (guidance was 50.6%) resulted from manufacturing efficiencies and higher growth rate of product lines with higher gross margins. Guidance is for 50%.
Decline in Flow Ratio comes from decrease in A/P, which may be indication of the tight market. A/R and inventory grew more slowly than revenues, however, and cash conversion cycle improved by 17 days, indicating good current asset management.
Recent quarter conference call indicated that operations did not fund expansion as it had in the past, due to ambitious goal to ramp production by 4X in 18 months.
Goodwill and other intangibles from acquisitions totaled $19.8billion and are being amortized over 3 to 15 years with an amortization expense of $896.9 million in FY 00. This expense is expected to grow to $4.5billion in FY 01 with SDLI acquisition.
Guidance history on earnings: April YOY, 75% (with Etek acquisition); May, 80%; June, 90%; October 26 on quarterly earnings conference call, 115-120%.
Guidance for next quarter:
Eps growth: high teens (2 to 3 cents higher); for year, from 70 cents to 80 cents
Sales growth: 115-120%
Gross margin: 50%
Operating margin: 28-30%
R&D expenditures: 8-9% of sales
(http://www.fool.com/dripport/2000/dripport001109.htm) |
