How High Can Optical Stocks Fly?
Unlike the dot-coms, these companies are showing they know how to make a profit
Wall Street can be forgiven for looking gift horses such as optical networking in the mouth these days. There's a list of technology sectors that spent 1999 smokin' but now are in flames. Then this summer's optics deals blew the dot-com record book away. On July 28, for example, Corvis Corp. (CORV) went public and earned a market cap of $28 billion--more than initial valuations of priceline.com (PCLN), eToys (ETYS), TheStreet.com (TSCM), and iVillage (IVIL) combined. And oh yes, at one point during the first day of trading, Corvis, then still awaiting its first dollar of sales, was worth more than General Motors Corp. (GM) Can this be real, or is it Dot-Com Tulipmania II?
That question has sparked a passionate debate in financial circles. Some, such as Robertson Stephens analyst Paul Johnson, say the optical opportunity is even bigger than previously thought: He thinks telecom carriers will spend up to $1 trillion on next-generation gear in under 20 years. Venture capitalist John McQuillan, who invented a key protocol used in almost all modern Internet routers, says the emerging generation of optics will likely set off the biggest wave of wealth creation since the transistor's invention in 1947.
Others are skeptical. Many investors worry that valuations got way ahead of themselves, much like they did for Net companies. Optical gearmaker Sycamore Networks (SCMR) Inc. saw its stock soar to 100 times estimated sales for this year and a cool 1,000 times its projected earnings. JDS Uniphase Corp. (JDSU), the leading maker of optical components, traded as high as 300 times expected net income. Compare that with the stocks of the companies in the Standard & Poor's 500-stock index, which are valued at an average of 29 times earnings. Worse, there are concerns that demand may flounder. Lehman Brothers Inc. telecom analyst Blake Bath points to a looming profit crunch at major telephone companies that could limit their ability to make massive capital investments.
Still, optical stocks are nothing like the dot-coms that crashed and burned. For starters, the financial model for telecom-gear companies is infinitely better than, say, Net retailers. Optical companies are proving that they can reach profitability quickly and enjoy fat profit margins after that. Sycamore is a prime example. It went public last October and turned profitable two quarters later. Its 47% gross margins are more than twice as high as Amazon.com Inc.'s (AMZN). ''They've done more in a year than Cisco Systems Inc. (CSCO) did in the first four after they went public,'' says Roger McNamee, general partner at Integral Capital Partners in Menlo Park, Calif., a money manager who invested in both companies. And those margins tend to stand up over time. Mature optics companies such as Ciena Corp. (CIEN) and JDS Uniphase sport gross margins of 45% to 47%, vs. half that in traditional manufacturing.
There's another telling aspect of this financial model. Once a company develops a hot product, sales explode. For example, Cerent Corp. (CSC) had almost no revenues when Cisco bought the maker of optical gear for $7 billion last summer. Now, Cerent is generating sales at an annual rate of $1 billion and growing.
It helps that demand for what optical companies sell is exploding. E-tailers sold things people already had and didn't especially need more of. The Web didn't make people take more pills, wear more watches, or read more books. By contrast, telecommunications providers that buy optical networking gear are being swamped by a tidal wave of Internet traffic. They need more capacity urgently, and deregulation-spurred competition means that they have to provide it more cheaply than ever. Broadwing Inc. (BRW), a telephone company based in Cincinnati, says it has to double its network capacity every few months, and optical equipment is the only way to do that efficiently. Chief Financial Officer Kevin Mooney says the equipment he buys from Corvis allows him to handle four times as much traffic for the same price as the gear he bought last year. Market researcher Dell'Oro Group predicts that spending on optical equipment will hit $44 billion this year--up nearly 50% from last year.
Of course, it's possible to lose money on optical companies. Most of the stocks have gyrated in recent months because of concerns about their valuations and telephone companies' capital spending. Sycamore has slid 40%, to 111. JDS Uniphase and ONI Systems Corp. (ONIS) have seen their shares dip 30%.
There are also risks inherent in these businesses. Some of these companies--Corvis, Sycamore, and ONI among them--still have narrow product lines and short customer lists. So their outlooks can sour very quickly if they lose a single order or get trumped by a competitor with better technology. Ciena lost 90% of its value after failing to bag a key AT&T (T) deal in 1998--though its stock has come back and headed higher since then.
Still, most experts think the sector as a whole has tremendous potential. With so much money being spent on optical gear, there are going to be some huge winners. William Heflin, a managing director at Kinetic Ventures who invested early on in Ciena and Cerent, is buying some public stocks this year because he thinks there are bargains. ''Maybe we have a mania,'' Johnson says. ''But the bet is that five to seven companies are the next Lucent or Cisco.''
The question is which five to seven companies. Start with Sycamore and Corvis, two of Johnson's top picks. One key reason he favors them is that both companies have disclosed big contract backlogs. Corvis has $550 million in orders and Sycamore has more than $1 billion. That should keep revenues humming in the years ahead. Another key metric to look for is a diversified product line. JDS Uniphase, for example, sells a wide range of optical components, including lasers and optical switches. That should insulate the company even if it falls behind in one product line.
The prospect of telephone companies slowing down their capital spending does worry some investors. Geoff Yang, a partner at venture firm Redpoint Ventures in Menlo Park, Calif., says he's insisting on paying less for stakes in optical startups partly because telecom players are struggling. Those fears were exacerbated on Sept. 20, when Sprint Corp. (FON) announced that it will miss Wall Street's expectations for the third quarter.
But telecom-equipment analysts make a forceful case that these worries are overblown. Why? They've seen it all before. Back in the fall of 1998, BT Alex. Brown Inc. reported that telecom companies were going to clip their capital spending in 1999. Instead, capital expenditures rose 31%, to $74.5 billion. Why? Phone companies wanted to reduce their spending on new equipment, but Net-fueled demand for capacity overwhelmed them. ''Anyone who has ever bet on carriers cutting capital spending has been wrong, wrong, wrong,'' says Jennifer Pigg, an executive vice-president at market researcher Yankee Group Research Inc.
The booming popularity of the Web is continuing to push telecom companies to their limits. Chief technologist Michael O'Dell of WorldCom Inc.'s UUNet (WCOM), which carries more Net traffic than any other company, says he's already planning for optical machines that handle quadrillions of bits of data per second--up to 1,000 times more than the machines hitting the market today. That may be mind-bending, but here's the simple part: Intermittent risks aside, optics is a good bet. |
