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I know two American engineers who have relocated to China to lead optical module design teams at Chinese equipment companies. They live and work in China for Chinese companies, using their skills to build custom modules - skills no longer in demand from their American Tier-1 telecom equipment employers.

Huawei and ZTE are more than happy to make use of their knowledge. Unlike most big Optical Equipment suppliers, these Chinese companies have gone counter to the trend of buying off the shelf optical modules. Instead, they continue to homebrew their own optics for the most demanding applications.

Huawei and ZTE understand how to gain a competitive advantage in high end Optical Transport; you cannot outsource a core competency to Bookham (BKHM), Avanex (AVNX), or Opnext (NASDAQ:OPXT).

One of the more interesting speakers at the Gilder Conference was John Rutledge - I blogged his talk here. He wrote a short summary of his impressions of China gleaned from his latest visit. He summarizes the threat China presents to the USA:

The big words in China are entrepreneurship and innovation…The Chinese government knows they will not be able to continue growth through manufacturing. There is not enough oil, gas, and coal and the air and water quality is terrible. They have decided to grow by investing in IT (fiber optic communications networks) and human capital (education) to increase productivity. Fighting over textiles is yesterday’s war. We should be thinking about where Cisco puts their next R&D facility. China is currently bidding very hard for such operations to relocate to their country.

They may not need to bid, as many readers already know. Huawei has vaulted to #2 supplier of optical networking hardware in the world with a 9.5% share without even selling large quantities to tier-1 carriers.

I’ve been negative on Ciena (NYSE:CIEN) for a long time because I believe their metro transport products are the most vulnerable to overseas commoditization. I believe that the only optical transport equipment companies that will profit and thrive in the long term are those that attempt to develop an internal component edge through R&D, like Infinera, or are big enough to sell an entire platform of products and perform the system integration - like Alcatel (ALA). Huawei is aiming to do both.

Huawei has already taken a dominant position in DSLAMs (#2) and Optical Transport (#2). So, what’s next?

I think the answer is easy - Layer 2/3 switching for the Enterprise. Cisco (NASDAQ:CSCO) has 70% global market share in this area and derives at least 50% of their operating income (my calculations, includes optical module resale) from this business. Competition has effectively thrown in the towel with the exception of (surprise!) the Huawei / 3Com (COMS) joint venture. Huawei/3Com has secured 35% market share in China and has grown revenue 70% annually since 2004.

Important Footnote: I have expressed reservations about the accuracy of Huawei’s numbers (see Huawei 2005 Revenue).

Full Disclosure: I am short Cisco as a hedge against other positions.

Source: China's Optical Threat to U.S. Networking Companies