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OK, since I’ve been called out by Om Malik, I’m going to let rip with a stream-of-consciousness monologue on optical. No backspace key, no delete key, spelling corrections ex-post-facto. Here goes.

Optical Components - Competitive environment still sucks. Too many suppliers are trying to kill each other. The market is divided into two sectors, low-end (1/2/4G SFP modules, including FTTH) and high-end (DWDM, Long Reach, Amps, ROADMs, exotic stuff). Cisco (CSCO) buys 70% of the low end and effectively plays the suppliers against each other. Suppliers need to stop playing their game. High-End fundamentally has a better business environment but I do not understand why those vendors haven’t finished their cost cutting. JDSU (JDSU) engaging in schizophrenic business plan pursuing both test equipment and optics. They need to decide what their mission is. Bookham (BKHM) talks the right game about consolidation but can’t seem to generate positive cash flow. Avanex (AVNX) is off my radar, last sighted with bloated French (legacy Alcatel (ALA) division) opex and descending fast through 10k feet. Best investments here are the companies that own the technical high ground, the lasers, detectors, fabs etc. and have the unit volume to leverage those investments. That’s Finisar (FNSR), Bookham, and Avago (Owned by KKR/Silverlake). Still unclear what impact China will have.

Communications Silicon - Everyone I speak with indicates semiconductors for optical equipment are on FIRE. Forward Error Correction, SONET/SDH framers, PDH framers, PHYs, all going gangbusters. The problem is these businesses are buried in large companies (Vitesse (VTSS), Agere (AGR), Mindspeed (MSPD), Maxim (MXIM)) and it is difficult to get investing leverage on this trend. PMC-Sierra (PMCS) represents the best such opportunity. VDSL2, not optics, is the best way to play FTTH as millions of lines are retrofit - Centillium (CTLM) and Ikanos (IKAN) are the best plays here. Keep an eye out for Intel’s upcoming sale of their Telecom semi division.

PON - More heat than light. Problem is the market just isn’t as big as everyone thinks. Silicon is controlled by Broadlight (Private) and PMC-Sierra. Optics are pure commodities - the number one supplier of PON hardware, Mitsubishi Electric, doesn’t even buy modules. They make the optical sub-assembly themselves. There are around 5M PON modules sold a year, compared with 15M 1/2/4G SFPs. Gross profit on each is around $4. Big Effin Deal. Investors who hitch their hopes on FTTH pulling the optical wagon aren’t going to roll far until someone other than Verizon (VZ) and NTT let loose, someone like China Telecom (CHA). GE-PON beats G-PON in volume 5:1 in 5 years.

Optical Equipment
- Infinera (private) is the real deal and represents the best example of innovation in the business. Unfortunately, this is not ‘unseen‘. Everybody know this, and it will be hard for this equity (when it finally is one) to exceed high expectations. Second best innovator is Huawei and represents the long term threat to Ciena (CIEN). Ciena has concentrated all firepower on being a transport company after sinking huge diversification investments that failed to hockey-stick. Only exception is Internet Photonics, which mothered the CN4200 product, a simple but effective Ethernet transport platform. It’s a great box, much like the revolutionary Cambrian box Nortel (NT) acquired (now called the 5200), but hardly the basis to support a $2B company. Ciena needs more technical innovation to survive and beat back Huawei, the ultimate commodity player. Lucent (LU) employees better learn French and Italian because Alcatel (ALA) plays better politics and is going to own them - 5 years from now very little of today’s Lucent will survive. The Nortel OM6500 is a hidden gem that could reverse the optical fortunes of that company. Cisco (CSCO) is still not a player. Adtran (ADTN) is a good way to play multiple trends we see in optical.

Carriers - The real estate boom is over, but the dark fiber real estate boom is underway. The consolidation in this business is finally underway and will result in improved margins for all. Dark Fiber in the ground is undervalued and future operators of that fiber will extract better margins. Abovenet (ABVT) is our favorite. Companies with high-replacement cost fiber in metro areas are best positioned. Long Haul fiber is less attractive. The Bellcos have all the opportunity to dominate the next century but have not exhibited a will to adopt revolutionary business models. Either they will be the next airline industry, undercut by a telecom Southwest, or evolve into massive cash-flow organizations with huge infrastructure competitive advantages, like Big Oil. The sequel to Syriana might be about the big Bellcos. Too early to tell, but they look good to me in the short term and we’ve been long telco and short cable (yes, ouch). Cable was created by Telecoms failure to act. They evolved (Cable Modems). They rebelled (VoIP). And they have a plan.

READ THE DISCLAIMER. These are opinions, NOT investment advice.

Source: Winners and Losers in the Optical Communications Market