Four reasons to take a second look at optical stocks
Suppliers of equipment used to build computer networks have been high-profile victims in the
tech wreck. But if you believe there'll always be a hunger for bandwidth, there are deals to be
found.
By Michael Brush
Aside from the dot-com disasters, few stocks symbolize last year’s excessive Internet investment mania -- and
bloodletting -- like optical equipment suppliers.
Most of these former photonic darlings, like JDS Uniphase (JDSU, news, msgs), still
trade more than 80% below their 2000 highs, despite sharp gains in the past weeks.
Their problem: Many investors have serious doubts about excess factor capacity and
the lack of potential demand for all that bandwidth.
But these doubts are misplaced, say industry insiders, analysts, and money managers who hold these stocks.
No one expects the former highfliers to get back to recent bubble levels anytime soon. “But long term, the
industry is going to fly,” says Minyi Tang, an analyst at San Jose, Calif.-based Firsthand Funds, which holds
shares in several optical stocks. “It is not going down the drain.”
“The underlying trends are intact,” agrees Paul Engle, the president of Avanex (AVNX, news, msgs), which
makes optical systems. “The use of communications is an integral part of modern commerce. And the systems
are not nearly as efficient as they need to be, because the volume of traffic will be much larger than it is today.”
Does this mean you should simply buy shares in networking leaders like Nortel Networks (NT, news, msgs),
Cisco (CSCO, news, msgs) or Lucent (LU, news, msgs)? Because earnings are so uncertain at these sprawling
giants, that’s probably not the best approach. (Robertson Stephens networking analyst Paul Johnson, for
example, thinks Cisco would be fairly valued at under $8 per share.)
Instead, a better way is to target smaller companies directly benefiting from narrow pockets of healthy capital
spending in the optical space. Here’s a wrap-up of the four main industry spending themes, and many of the
companies best positioned to gain from them.
Four reasons to believe
“Metro access” infrastructure is now the name of the game, not long-haul transport. “During the past
two years, the industry was building out the core, or the backbone,” says Tang. “But the metro space is the next
bottleneck. Metro is the next big wave.” In short, telecom carriers need to beef up local access to bring more
customers on line, so they can make money off those long-haul investments.
Business in this corner of the optical world is indeed booming. For example, ONI Systems (ONIS, news, msgs) --
one of the leading suppliers in the metro space -- beat estimates this week and laid out a positively rosy scenario
in its conference call. That had analysts bumping up guidance. The stock rose sharply to the $38 range on the
news.
Other signs of demand: Verizon (VZ, news, msgs) recently told analysts it has a backlog of unfilled orders
because of limited capacity in its metro and local access networks. And Nortel says it expects metro spending to
increase by up 40% to 50% next year, albeit off a small base.
Besides ONI Systems, a smaller company with excellent exposure to the metro spending trend is Optical
Communication Products (OCPI, news, msgs). Just be aware that Cisco -- which has its share of problems
right now -- accounts for an enormous 35% of revenue. Next, Wit Soundview analyst Kevin Slocum believes
Finisar (FNSR, news, msgs) will become “the JDS Uniphase of the metro access market.” Finisar gets a lot of its
revenue from sales in the data storage market as well, which analysts believe will return to health once the
economy picks up. Stratos Lightwave (STLW, news, msgs) also has good exposure to the metro space.
Companies with mixed or little metro exposure include:Corvis (CORV, news, msgs), Avanex, New Focus
(NUFO, news, msgs) and JDS Uniphase. These companies maintain there will be a pickup in long-haul spending.
We’ll get to the important matter of when in a moment.
Tools and testing gear used in lighting up existing fiber are in great demand.
Carriers may have stopped spending on long-haul capacity for the moment. “But they are busy lighting up dark
fiber by adding transmitters and receivers,” says Dave Kang, an analyst who follows optical stocks for ABN
AMRO. “These carriers are opting to squeeze as much as they can from current networks, rather than build new
ones. So they need test and measurement equipment.” Williams Communications Group (WCG, news,
msgs), for example, says it hopes to boost capacity usage to 60% from 30% by the end of the year.
Given this trend, it’s no surprise that two of the main testing equipment companies -- EXFO Electro-Optical
Engineering (EXFO, news, msgs) and Digital Lightwave (DIGL, news, msgs) -- traded up sharply this week
after reporting strong quarters. EXFO moved straight through 12-month price targets in the $38 range before
dropping back on Thursday.
Now for the bad news: Testing equipment also gets put to use by optical gear makers in manufacturing, which
has hit a lull. Digital Lightwave has less exposure to manufacturing than EXFO. “But there is a push toward
next-generation equipment, so there is a lot of research and development going on which creates demand,” says
Slocum. New Focus also has exposure to the test and measurement equipment market.
Companies selling "active" components have an edge over those selling "passive" components.
What’s the difference? Active components such as lasers have more “intelligence,” and they contain more
sophisticated electronics, says Kang. Companies producing active components enjoy decent barriers to entry
and higher margins. Passive components are lower-intelligence, legacy products such as filters and circulators.
“Lower intelligence means lower differentiation,” says Firsthand Funds' Tang. And that means more pricing
pressure and lower margins.
Pure passive component vendors that could face trouble because of this concentration include Oplink (OPLK,
news, msgs) and Alliance Fiber Optic (AFOP, news, msgs).
Companies producing active components, or systems that use them, include Optical Communications, Corvis,
Aeroflex (ARXX, news, msgs), Finisar, Bookham Technology (BKHM, news, msgs) and Stratos Lightwave
(STLW, news, msgs). Firms with a foot in both camps include Avanex, JDS Uniphase and New Focus.
Carriers will favor companies whose components and systems save money by making transmission
more efficient. This is where things get a bit more complicated. But essentially, this means you should look for
firms specialized in making sophisticated, next-generation optical equipment. Picking which ones will actually
come out on top is another matter, since by definition, a lot of this gear remains untested.
But a few things are clear.
First, spending on this cutting-edge equipment still represents only about 18% of capital budgets at carriers. So
there's room to grow -- or at least less potential space for cutbacks. Second, while telecom equipment leaders
like Nortel, Cisco and Lucent are paving the way with many advances in this camp, a big portion of their business
is actually in older, legacy products and systems. Bottom line: They are not a great way to play the leading-edge
technology.
Instead, look for the companies that focus solely on producing equipment that makes the big, dumb, fiber pipes
carry out more nimble tasks. While optical networks still mostly provide transport, at some point they will contain
lots of gear that performs advanced switching and provisioning tasks. This will help carriers better manage
individual wavelengths inside the pipe. That way, they can do things like quickly reallocate bandwidth as end user
demand shifts. Provisioning changes now can take a lengthy six months.
Who are some of these companies? Here is a quick rundown.
Ciena (CIEN, news, msgs), which sells the CoreDirector optical switch, was among the first to stake out market
share in this space. It’s now a leader in optical switching. “Ciena is pure optical, which is pure adrenaline,” says
one analyst. Another early mover in cutting-edge optical switches was Sycamore Networks (SCMR, news,
msgs) -- though investors currently are waiting for positive news on its next round of products.
Next, all-optical switches made by Corvis eliminate the need for conversion of wavelengths to electrical signals for
regeneration during the long-haul journey. This helps speed up provisioning. Avanex has also developed all-optical
gear that helps carriers manage the transport of light without converting it to an electrical signal.
“Tunable lasers” -- in the works at New Focus -- offer the potential for remote provisioning of bandwidth, since they
should permit carriers to change optical signals at the source.
And optical equipment made by ONI Systems is popular because it helps telecom companies quickly reconfigure
metro networks, says Jim Smith of Mohr Davidow, which helped finance the company in its early stages.
It all depends on bandwidth demand
Looking beyond these fairly focused capital spending trends playing out right now, what’s in store for overall
bandwidth demand?
It won’t pick up until big enterprises like General Electric (GE, news, msgs) and DaimlerChrysler (DCX, news,
msgs) start ordering bandwidth, say analysts at Thomas Weisel Partners. Forget home users. Next, carriers
need to have access to the debt and equity markets again so they can raise capital. Then there is all that excess
bandwidth capacity and equipment inventory to work through.
When will all the stars align? At best, throughout the second half of this year, though no one really knows.
But for Wit Soundview’s Slocum, it is only a matter of time. “I have little doubt we are going to continue to
consume bandwidth capacity. Personal computer storage has doubled every two years for the past decade. And
to me, the network is nothing more than virtual storage.”
In the meantime, some revenue and spending numbers contain an ominous sign for telecom equipment suppliers.
If you add up their expected revenues for the rest of the year, the figure is well below the capital spending
projections at all the carriers.
“Some analysts on the Street have turned positive on the group, but we still think the fundamentals are very
negative,” says Tim Ghriskey, a portfolio manager with Dreyfus, who has cut back to core positions on optical
stocks. “There is a lot of capacity that is not going to go away quickly.”
Here’s the next chance you’ll have to get a glimpse of the future. Watch for comments on capital budgets and
excess capacity when big carriers like Qwest (Q, news, msgs), SBC Communications (SBC, news, msgs),
Verizon, AT & T (T, news, msgs), Worldcom (WCOM, news, msgs), Broadwing (BRW, news, msgs) and
Global Crossing (GX, news, msgs) announce earnings next week.
At the time of publication, Michael Brush owned or controlled share in the following equities mentioned in this
column: JDS Uniphase, Corvis and New Focus.
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