WSJ on fiber optics:
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August 15, 2000
TALES OF THE TAPE: Optical Parts Makers Latest Net Play
By RICK JURGENS
OF DOW JONES NEWSWIRES
PALO ALTO -- Investors anxious to make an Internet play, but fed up with losses at dot-coms, are now turning their attention to makers of optical network components.
Right now, demand for optical components, which help the Internet deliver information more quickly, is so strong that any company that can turn out usable products looks like a short-term winner.
"You can't miss," said Rich Scheuermann, an analyst with Dresdner RCM, a San Francisco fund manager.
But investing in the sector still isn't for the faint of heart. Stocks are very expensive, and it's hard to judge which of the handful of publicly traded companies will succeed as high-volume production and price competition increase.
Fiber optic networks transmit data by pulsing light over strands of fiber. They are faster and less susceptible to electromagnetic interference than older communications networks, which send electrons over copper cables.
The Internet's growth is fueling demand for network capacity. About 40 million miles of fiber are expected to be installed by the end of 2001, up from less than 30 million miles in 1998. New equipment is also increasing the volume of data that can be sent through each strand.
Makers of that equipment, led by Nortel Networks Inc. (NT) and Lucent Technologies Inc. (LU), have run into a bottleneck as they try to ramp up production: a shortage of components.
Optical network equipment makers constitute "a market with an insatiable appetite," said Dan DiLeo, president of Lucent's optoelectronics division.
Total sales of optical components were $6.6 billion in 1999, and are expected to reach $23 billion in 2003, according to RHK, a South San Francisco, Calif., market research firm. <RHK estimated in March that 2000 sales would be just under $10 billion but now plans to raise that estimate, said Peter Chen, a senior analyst.
Such growth prospects are reflected in the $41 billion bid that JDS Uniphase Inc. (JDSU), San Jose, Calif., the largest stand-alone components maker with $1.4 billion in annual sales, has on the table for SDL Inc. (SDLI), the No. 2 independent, also in San Jose. That deal, which is awaiting approval from regulators, values SDL at more than 140 times its $289 million in annual revenue. At Friday's closing price of $117.75, JDS' own market cap was a cool $92 billion - more than Sony Corp. (SNE) or Walt Disney Co. (DIS).
Tiny companies also have high valuations. Finisar Corp. (FNSR), a Sunnyvale, Calif., optical subsystem maker, had a $4.3 billion market capitalization at Friday's closing price of $26.88 - more than 60 times trailing-12-month sales of $67 million, and more than 1,400 times earnings.
Finisar seems like a bargain compared to Bookham Technology PLC (BKHM), a London optical component maker, which had a $7.4 billion market cap at Friday's closing price of $63 - despite losing $28.6 million on sales of $7 million in its last four quarters.
Valuations Concern Some Analysts
Investors' exuberance over the shares has some worried. There are too many start-ups and too many investment dollars seeking a place in the industry, said Wu-Fu Chen, a venture capitalist who heads up several optical network companies.
Dan Smith, chief executive of Sycamore Systems Inc. (SCMR), a network equipment maker, said that "a torrent of liquidity" has raised valuations of some companies to levels not supported by their business potential.
But Scheuermann, the Dresdner RCM analyst, said optical component stock valuations are "high, not obscene."
With every publicly traded company in the space positioned to deliver strong growth to investors for at least another 12 months, there is little danger that multiples will sag soon, he said.
Companies delivered growth in their most recent quarters. JDS Uniphase, with sales of $524 million, was up 173% over a year ago; SDL, with $110.5 million in sales, was up 156%; Finisar, at $20.7 million, was up 68%; and tiny Bookham, at $7 million, was up 1,018%.
Growth isn't a huge challenge in the current market. Equipment makers "are so dependent on components that suppliers are demanding long-term contracts," Scheuermann said. Three-year deals aren't unusual, and some contain take-or-pay provisions which require customers to pay for fixed quantities of parts even if they don't use them, he said.
That bargaining power has helped component makers boost selling prices above costs, even though most depend on labor-intensive production lines where maintaining a high yield of usable products is a constant challenge.
But like other makers of high-tech hardware, optical components makers will eventually face pressures to automate and ramp up production, cut costs and develop better technology. "To realize your vision, you need a wide range of components and modules, including ones that haven't even been invented yet," reads a glossy brochure JDS Uniphase distributes to potential customers.
Analysts disagree as to how soon a shake-out among component makers could begin. It's "very premature" to worry about the impact of high-volume production and severe price competition, said Arun Veerappan, an analyst with Robertson Stephens.
But Thomas Astle, an analyst with Merrill Lynch & Co., said high-volume production of some types of components could begin as early as the second of half of 2001.
In the meantime, investors can also hope to cash in on "take out premiums" if small companies are acquired, Scheuermann of Dresdner RCM said. Large makers of components and optical network systems also have stocks priced at high multiples of revenue and earnings, so they can afford to pay dearly to acquire new technologies, he noted.
While stock valuations in the sector could be hurt by new offerings from weak companies, such offerings are likely to be limited by challenging technology and a shortage of qualified engineers and scientists, he said.
So far the market doesn't seem to have had its fill of initial public offerings from component-makers. Bookham's stock closed Friday at $63, quadruple its April IPO price of $15.83. Stratos Lightwave Inc. (STLW), Chicago, closed at $34.06, up from its June IPO price of $21; New Focus Inc. (NUFO), Santa Clara, Calif., was at $120.75, more than six times its May IPO price of $20; Avanex Corp. (AVNX), Fremont, Calif., was at $132, more than triple its February IPO price of $36.
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