I f you've ever invested in fiber-optic telecom stocks, especially during the dot-com boom and bust of the late 1990s, you know that they're cyclical and volatile. You also might know it's an industry that today could profit -- that is, cut down on margin-eroding pricing competition -- from further industry consolidation.
But you're probably in the dark about how these companies, which enable digital data to whisk through phone company networks as rapid pulses of light, have diversified their customer bases.
Internet companies such asGoogle ( GOOGL ),Amazon.com ( AMZN ) andFacebook (FB) have become big buyers of optical components and system-level products. They use optical technology to connect data centers packed with racks of computer servers to high-speed telecom networks.
At Ciena, Internet companies are now about 10% of revenue, analysts say.
The hot market now talked about on fiber-optic company earnings calls is called DCI, for data center interconnect. Ciena is the No. 1 DCI supplier. DCI gear handles server-to-server traffic and provides high-speed links between data centers.
The high-speed DCI optical market will boom to $4 billion by 2019, up from $400 million in 2013, forecasts market research firm ACG.
Dmitry Netis, analyst at William Blair, says that fiber-optic gear makers face a challenge designing new products groomed for data centers as opposed to those engineered for telecom networks.
"When the data center opportunity popped up, with Web-scale guys like Google building their own data centers, there weren't optical products that would fit that cloud infrastructure model," said Netis. "DCI is the answer to that for the optical transport side of things, designing a box sitting directly in the server rack, optimized for size, optimized for power dissipation and shooting out the data traffic at high speed.
Netis says that 2016 revenue growth is largely tied to DCI sales as well as an expected upgrade cycle by phone companies to much faster 100-gigabit-per-second transmission from current 10-Gbps or 40-Gbps network gear.
Demand for cloud services is driving networking hardware upgrades. Telecom companies are upgrading in metropolitan areas, where data traffic from business customers, Internet video and other sources is aggregated, before being whisked over bigger, long-distance pipes that span the U.S.
Connecting multiple data centers, either across the globe or in local, metropolitan areas, is now the name of the game for Web 2.0 companies aiming to bring content closer to consumers and mobile devices.
Infinera 's (INFN) CloudXpress gear connects data centers. The company calls it a "metro cloud."
"The big ICPs (Internet content providers) continue to drive the biggest volumes," said Infinera CEO Thomas Fallon on its July earnings call. "At the end of the day, what they have to do is get data from one data center to another data center or get data, information or video from data centers to consumers."
Ovum, a U.K.-based market research firm, forecasts that 2015 capital spending by ICPs will rise 18% to $67 billion.
"The increase is driven by heavy spending on data centers, content delivery networks (CDNs) and related cloud infrastructure, especially from Google,Apple (AAPL), Amazon andAlibaba (BABA)," said an Ovum report.
Video streamerNetflix (NFLX), which has built its own CDN, is a Ciena customer, says Nomura Securities.
The White Box Challenge
Still, it may be too early for fiber-optic gear makers to raise glasses and toast the arrival of the DCI market.
Internet companies have lowered data-center costs by running software on so-called "white-box" servers and network switches often built by lesser-known suppliers, not brand-name equipment. They aim to buy less specialized hardware and custom-developed solutions.
Internet companies have plenty of in-house engineers enabling them to design their own data centers, using a "do-it-yourself" approach and buying cheaper, off-the-shelf components. One worry is that Web companies could do the same for optical technology as they have for servers and network switches.
Infinera's Fallon says that gross profit margins in the optical industry are in the low 40s, compared to 70% in the networking switching market. So, optical gear is less vulnerable to "white box"-style competition, he says.
"ICP guys building white box optical switches or transport boxes? To me, it's just not efficient," he said on Infinera's Q2 call.
Infinera and networking vendorArista Networks (ANET) have teamed to market products to data-center customers.
In 2015, Infinera's stock has shot up 40%. Ciena is up 8%, after dropping 20% below its mid-July high. Shares of chipmakerAvago Technologies (AVGO), a player among optical components suppliers, are up 26% so far this year.
IBD's fiber-optics group ranked 44th among 197 groups, down from No. 5 just five weeks ago.Finisar (FNSR) shares tumbled 18% on Sept. 11, helping to dent the group's performance, after the company reported on Sept. 10 disappointing fiscal Q1 revenue and earnings, and forecast current-quarter results well below consensus estimates amid the resignation of its CEO.
While Infinera and Ciena build higher-margin system-level products, price competition has heated up for optical component makers, where margins are in or below the low 30% range.
Anatomy Of A Shakeout
The big question for the optical industry is where profit margins are heading. That's where M&A comes in.
A proposed merger betweenAlcatel-Lucent (ALU) andNokia (NOK), two large telecom-equipment makers, is expected to close by year-end. That deal, announced in April, could pressure Ericsson to acquire either Ciena orJuniper Networks (JNPR), some analysts said. Ciena and Ericsson have partnered to sell products to phone companies in Europe and Asia. Speculation has died down, though, over Ciena being acquired.
The fiber-optic components sector is in dire need of consolidation so that companies can improve profit margins, says Mark Sue, analyst at RBC Capital Markets.
JDS Uniphase in August split into two companies,Lumentum Holdings (LITE) andViavi Solutions (VIAV). Lumentum's customers includeCisco Systems (CSCO), Ciena and Google.
Shares in both Viavi and Lumentum have dropped since the split, as the outlook for M&A dimmed further.
When JDS Uniphase announced plans for the split in September, 2014, speculation quickly arose that Finisar would acquire JDS' Communications and Commercial Optical (CCOP) business, which became Lumentum. Finisar balked at the asking price, however.
With Finisar's struggles following its Q1 report, the likelihood of a merger with Lumentum has dropped sharply, analysts say. On the other hand, Lumentum has plenty of cash to make its own acquisitions, perhaps laser-related, analysts say.
But RBC Capital's Sue says the fiber-optics industry needs consolidation among Finisar, Lumentum,Oclaro (OCLR) andNeoPhotonics (NPTN).
Finisar and Lumentum are the two biggest fiber-optics parts makers, followed by Avago, Japan's Sumitomo and Oclaro.
"The competitive environment is intensifying, with Lumentum, InnoLight and others seeking market share," Sue said in a report.
Pricing pressure is most severe for older 10-Gbps components as the upgrade cycle for 100-Gbps gear gains traction.
One worry is that Internet firms will find new sources of next-generation optical parts.
In September 2014, Google invested in China-based InnoLight, which makes high-speed optical transceivers used by computer servers. Smaller suppliers -- including Acacia Communications andApplied Optoelectronics (AAOI) -- grew faster than larger vendors in 2014, spurred by demand from data-center customers and upgrades to optical technology, says a report from market research firm LightCounting.
"Google is likely to reduce its reliance on Finisar and may set the tone for other large, hyperscale customers such as Amazon, Facebook and others," wrote Sue in a report.
William Blair's Netis, meanwhile, says that component vendors such as Finisar, Lumentum and Oclaro could move upmarket. They may target system-level design and software capabilities of their own and become suppliers to "white box" server makers from Asia.
While M&A has been lacking in the components sector, both Ciena and Infinera have been busy gaining software expertise.
In August, Ciena closed a deal to buy Cyan for about $400 million.
Infinera bought Sweden-based Transmode in April for $350 million. The deal puts Infinera in the metro urban markets, a stronghold of Ciena. Ciena is expected to get a 2016 boost from Verizon's 100-Gbps metro upgrade.