Part 1 – Introduction

During OFC2008′s Marketwatch Panel I indicated consolidation was necessary and would happen faster than most people believed. I made the argument that all consolidation up to that point had been “Big buying Small”, not meaningful, and that only a large transaction between two major players would be a catalytic event. The slides I presented on consolidation are at the end of this article.

The merger between Finisar and Optium will be that event.

In February, Telecom and Datacom CEOs and other executives who participated in the OFC Executive Forum indicated the market was in a stalemate situation (only Joe Liu dissented). All indicated that consolidation was needed but when asked point blank if it would happen the answer was ‘no’. Here are a couple of quotes from Feb 25.

• Alain Couder, CEO of Bookham – “Consolidation for market share has not been successful … I don’t see any urgency.”
• Tony Musto, President of Sales and Marketing, Optium Corporation “No path to profitability exists through consolidation.”
• Jerry Rawls, CEO of Finisar – “Consolidation, as much as it is needed, isn’t going to happen.”  (whoops)
• Jo Major, CEO of Avanex – “Many barriers exist to consolidation.”
• Harry Bosco, CEO of OpnextMike Chan, EVP – “Everyone is talking about consolidation but no one is doing anything about it.”
• Joe Liu, CEO of Oplink – “Consolidation is imminent.”

Blu-Ray and Black Swans

Most readers are familiar with the (now settled) HD-DVD vs. Blu-Ray format war. You may recall that when 2008 began 2008 the consensus opinion was that a stalemate was at hand, and that the format war would continue indefinitely. This is not unlike the opinions of executives from five of the largest optical component companies, who only a few months prior claim that a change in the landscape is unlikely and difficult.

In the first week of January Warner Brothers, a studio whose content represented a 20% share of DVDs, abandoned support for HD-DVD. Within a week, the shift ended the HD format war.

No one saw Warner’s decision coming but the market reaction was immediate and complete. The decision caught HD-DVD players flat-footed booth at the 2008 Consumer Electronics Show (CES) and was so unanticipated that various press events and conferences on HD-DVD topics were either canceled or participants simply failed to show up. It’s the best recent example of a ‘Black Swan’ in the technology business.

The Fuse Is Lit

The outcome of the Finisar/Optium merger will not be immediately apparent like Warner’s decision to drop HD-DVD was. The optical component business moves much more slowly than consumer electronics. However, both have set in motion an irreversible sequence of events that have an equally non-linear outcome, a sequence of events that onlookers thought impossible only a few months before. News of the merger event is rippling through the industry and adjusting the markets perception.

This future looks something like this:

• The Finisar/Optium entity will create an optical Hegemon, with superior scale and cost efficiency when compared with its peers.
• Other companies in the same sector now have no choice but to consolidate in an attempt to reach a similar state- or be marginalized. At some point investor or peer pressure will crack management resistance to consolidation.
• Macro level capacity is reduced and duplicative fixed cost spending will drop. Pricing power will improve. Profitability improves for some.

Here is an excerpt from a note I published on May 16th, immediately following the merger announcement.

This is the beginning of a bull market in this sector. This kind of thinking will fix much of what is wrong. Others will now need dance partners. Pressure will be on for consolidation. If they do not, the big player will put others under their thumb.

In the short term, while consolidation is underway, the above remains true. What will be more difficult is understanding the stage that follows, as consolidation is a messy, destructive, and wealth-destroying process. It is Schumpeter’s creative destruction at it’s finest. But participants tend to focus on the creativity of such times but overlook the destruction. One must look at the impact of both, something that will unfold in a coming series of articles.

Part 2 – What Consolidation Accomplishes

Part 3 – Quantitative and Qualitative Analysis of Finisar/Optium Merger

Part 4 – Broader Market Trends in Optical Component Consolidation

Stay tuned.

Below are excerpts of slides from the Nyquist presentation made in February at OFC

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Emcore is a company we used as a hedge in 2006 as we expected it to face tough tough sledding due to it’s dependency on 10GbE LX-4 optical transceiver revenue at Cisco. In 2007, everything went upside-down as investors took notice of it’s aerospace solar business, re-classified it as a Solar Stock, and ruined whatever correlation it had with the optics business. The price of the stock became de-coupled from conventional metrics, as all companies involved in perceived booming industries do.

The optical industry, including Emcore, experienced the same thing between 1998-2000. As many of us learned then: If you live by the boom you die by the boom, because the convictions of investors that participate in such events are weak. These convictions are based mostly on what others think and do, rather than what they themselves believe to be true. And these convictions can turn rapidly when investors sense the crowd is surging for the exits.

A recent post at Citron Research highlighting perceived issues with the integrity of Emcore’s solar backlog was all it took to shake the convictions of those who decided they wanted to be solar investors. The issues raised by Citron were not earth shaking and from our perspective relied on little ‘unseen’ information. Investors and analysts who follow the solar business should have been aware of these issues; perhaps they were and had legitimate reasons to dismiss them. Perhaps some of Citron’s data is flawed. Regardless, the herd surged for the exits.

The fact that relatively public information can have such a profound effect on the public valuation of a company is indicative of a lack of understanding within the shareholder base of their solar business.

Emcore sold $94M in stock (at $12.50/share) and warrants last month to an institutional investor base to fund the purchase of Intel’s optical components group. The investors are now sitting on a 50% loss. The company also convinced it’s convertible bondholders to swap their debt for equity at $7.50/share in an effort to clean up it’s balance sheet. The stock was selling for $11.77 at the time the deal was announced.

In short, There are some very angry investors to be sure and it will be interesting to see how this all shakes out. The company is in excellent financial condition at this point at the expense of the new equity holders.

What do we think about Solar?

The solar business is just like the memory business, where 95% of the volume is capital intensive commodity manufacturing. In the meantime people are excited about the various technologies. But the endgame is unchanged; build a really big factory and operate the complex technology better than your competitors (like DRAM or Flash), or focus on niche solutions with higher margins and R&D (Like Netlogic, Rambus, and other specialty memory makes).

The sooner the market discovers this the sooner it can move on to the next boom.

Turning and turning in the widening gyre

The falcon cannot hear the falconer;

Things fall apart; the centre cannot hold;

Mere anarchy is loosed upon the world,

The blood-dimmed tide is loosed, and everywhere

The ceremony of innocence is drowned;

The best lack all conviction, while the worst

Are full of passionate intensity.

- William Yeats – “The Second Coming“