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One of our more popular theme pieces (see “Five Misconceptions About the 10G Optical Market“) examined the state of the 10GbE market and sought to identify the gaps between market perception and reality. It’s time to publish an update with the facts we have collected and opinions we’ve formed since then.

Growth? Is That Really You?

The market for optical modules in Enterprise applications (primarily 1/2/4G SFP’s) suffered through years of secular anemic growth, beginning in 2002 when shipments of copper based GigE ports overtook shipments of fiber based GigE ports. The emergence of copper based GigE effectively capped unit volume growth in the optical business while exposing participants to declining prices as they fought for a share of a fixed pie.

The graph below illustrates the unit volume growth in 1GbE port shipments, and the missed opportunity due to the emergence of copper based GigE connectivity. Not shown is SFP consumption in fibre channel end markets - about another 1M units/quarter - and not growing at a material rate.

You can understand why optical module vendors dream of an alternate history where the availability of copper based Ethernet was delayed.

However, we believe the secular decline in revenue from enterprise oriented optical modules is coming to an end. While copper GigE arrived at the beginning of the GigE growth cycle, we do not think 10GbE will suffer the same fate. It is clear copper 10GBASE-T cannot deliver the densities required for volume applications while SFP+ can deliver 100m reach for less than $100 today. 10GBASE-T shouldn’t reach power density (which is increasingly the critical specification) parity with SFP+ for at least 3-4 years. 10GBASE-CX is an interesting technology and is worth watching but requires yet another cable type.

Therefore, it doesn’t appear that any near term growth in 10GbE will be addressed by copper interconnect. And cost/density requirements will dictate that the growth in unit volume comes from SFP+ - not legacy XENPAK/X2/XFP form factors. All that is needed is a catalyst to drive market demand for 10GbE.

The Emergence of 10G Datacenter Ethernet

Based on public information from Equinix (NASDAQ:EQIX), Level3 (NYSE:LVLT), Akamai (NASDAQ:AKAM), IBM (NYSE:IBM) and other sources, it has become clear that the real driver of 10GbE unit volumes is not video but large capital expenditures in datacenters and datacenter interconnect. 10GbE is experiencing a ‘perfect storm’ of sorts as several trends converge:

  1. Companies consolidating data centers into fewer locations for various reasons, while simultaneously increasing their capacity.
  2. The emergence of computing in the cloud (Google Apps, Salesforce.com, corporate applications, etc.) driving the demand for datacenter oriented computing. This in turn drives demand for next generation Bladeservers with multiple 10GbE uplinks.
  3. Carriers adopting 10GbE and L2 trunking and switching as the basis for next generation infrastructure and re-purposing enterprise components to implement it. (see “LightReading Ethernet Conference Notes“)

It remains to be seen if Cisco (NASDAQ:CSCO) can extend its dominance of Ethernet switching into the datacenter space. As we discovered and made known before (see Cisco: The Optical Illusion), the 60% market share Cisco holds in the switching business results in an inefficient optical component supply chain market. Cisco has a monopsony on optical components and it extracts the majority of value rather than the suppliers themselves.

If Cisco market share slips significantly during the transition to 10GbE, this would break the back of the Cisco monopsony and usher in a much healthier operating environment for optical vendors overall. While such an outcome is far from certain it begs watching given the market impact it would have.

SFP+ Rising

10G SFP+ modules have very quietly started to ship in volume into the 10GbE and 8G FC market. The buyers are storage vendors and private datacenter operators, including Google (see “Google’s Secret 10GbE Switch“). The current volume run rate is approximately 100k units a year.

Other customers with large datacenter requirements may make the same decision as Google and move forward with the SFP+ form factor without support for 10GBASE-LRM and other long reach options. Datacenters are increasingly wiring with OM-3 fiber, which eliminates the benefits EDC based LRM brings to the table.

EDC certainly isn’t going away, but it is no longer the key market enabler. Netlogic (NASDAQ:NETL) purchased Aeluros, a maker of 10GbE PHYs who won dominant market share with their 10GbE PHY, but failed to make headway with EDC based 10GbE.

We expected the Aeluros market share to be undercut by new 10GbE PHY vendors like Cortina, Vitesse (VTSS.pk), and AMCC (NASDAQ:AMCC) who offered integrated EDC. It appears this conclusion was wrong, as the importance of EDC is waning. Rather than Netlogic mirroring the error AMCC made when it purchased Quake (see “Quake: Another Failed AMCC Acquisition“) it appears their investment may remain intact. However, Cisco is still taking a different approach and is making EDC a requirement.

O Cisco, Where Art Thou?

Using publicly released data from Cisco we estimate it will purchase at most 150k units of SFP+ in 2008, substantially less than half of total end market demand.

Why? Cisco remains 6-9 months away from shipping any equipment with SFP+ enabled hardware. Cisco has placed great emphasis on EDC and will not ship SFP+ until vendors deliver reliable silicon to interface with SFP+ optical modules.

As a result, Cisco will be buying more of the same 10GbE XENPAK/X2 modules for a period longer than the market expects. This is positive for incumbent suppliers such as Intel (NASDAQ:INTC) and Opnext (NASDAQ:OPXT), and negative for suppliers attempting to take share at Cicso such as Finisar (NASDAQ:FNSR). Finisar lost the opportunity to supply the only new 10G XENPAK module (10GBASE-LRM) when a last minute switch from a Japanese laser supplier caused problems with their design. It isn’t 100% clear to us who won this business (we believe Sumitomo and Avago) but we also feel it doesn’t reflect meaningful volume.

Conclusion

  • The 10GbE optical component market is hitting a growth knee as multiple trends converge to drive 10GbE port deployment. This is driving SFP+ module growth.
  • Best of all, it isn’t Cisco buying the majority of product, which should translate into better gross margins for component suppliers.
  • While “This time is different” are the four most expensive words on the planet, it does not appear copper interconnect substitution is a near term threat as it was during the transition to 1GbE.
  • Legacy form factors will be the dominant shipments into Cisco in 2008, but given the brutal pricing demanded by Cisco it isn’t clear that this business is really desirable.

Our impression is the investment community is overly focused on Finisar’s ability to take share at Cisco with a XENPAK product. Investors have also overlooked the disruptive nature of the AZNA acquisition and the low-cost 10GbE Telecom products it enables.

Our opinion is investors should be focusing on who will supply the SFP+ module market, a market which will be ultimately higher volume and less characterized by the corrosive effects of Cisco’s monopsony. And it is here that Finisar and Avago have large structural advantages over the competition.

Disclosure: Author holds positions in AMCC, Vitesse, Finisar, and Opnext.

Source: 10GbE Optical Component & SFP+ Modules: This Time It's Different