October 1, 2002 is the generally agreed upon day that marks the bottom of the bubble (Nasdaq low was Oct 9, 2002)and is a useful date to compare post-apocalyptic performance.

Finisar is the only optical component stock with a post-bubble positive return. During FY08 Finisar lost it’s ‘favorite son’ status when it failed to deliver expected growth.

However, its decline should be viewed as a mean reversion, not a decline of fortune. I believed the positive sentiment attached to Finisar in 2006 was absurd (see “Why I Don’t Own Optical Component Stocks (yet)”) but believe the negative sentiment today to be equally absurd.

FY09 Revenue Guidance

Finisar provided FY09 revenue guidance of +10-15% (exclusive of the Optium merger now underway). We like to look at the company as three separate segments: Test, 1-8G (SFP’s, Mostly Enterprise market driven) and everything else which we refer to as 10G/Telecom. 10G/Telecom is the growth segment of the company, while the 1-8G segment is mature from a unit volume standpoint. The company provides excellent data on segment performance.

Finisar’s total revenue for 2007 was $440M. About $267M was 1-8G, $39M was test and measurement, and $135M was 10G and Telecom. The company would need to reach revenues of $506M to grow 15% – what must happen to hit this?

• The company expected single digit growth in 1-8G for 2009. Some growth is reasonable as pricing in this segment has reached the point where smaller, marginal producers can’t survive. SFP prices have stabilized after years of decline. 8G SFP shipments are just beginning and Avago and Finisar are the only suppliers that matter here. But a conservative outlook requires this segment to stay flat. $267M.
• Assume Test and Measurement stays flat, though the company again indicated single digit growth. $39M.
• 10G/Telecom would need to grow 45% year over year to deliver the remaining $200M ($506M – $267M – $39M).

Summary: Assuming all other businesses are flat Finisar needs to grow it’s 10G/Telecom units 45% to reach the high end of revenue guidance. The below graph illustrates the segment growth required to hit 15% revenue growth.

The risks to this appear reasonable:

• 10G/Telecom grew at an annual rate of 87%, 55%, 79%, and 58% in Q1/Q408. It grew 70% FY08/FY07. The 45% annual growth is at the low end of the historical range.
• 10GbE unit volume in the SR flavors is accelerating rapidly, which is a low cost market segment where Finisar is well positioned.
• The Optium merger allows Finisar to serve 300-pin applications, moving it from a niche 10G module supplier to one that has a full spectrum of solutions. This should accelerate market share gains in existing 10G segments.
• 1-8G revenue volatility decreased in the last few quarters. Pricing stabilized. Competition decreased as marginal producers have been squeezed out. We also heard Avago was extremely aggressive in the last year as part of an effort to position the company for a liquidity event. The market shock this created ‘cleaned the competition pool’ and we don’t believe Avago will attempt this again.
• We’ve asked around the industry to identify scenarios where the 1-8G business ‘blows up’ and can’t find any. Our greatest concern is a general slowdown in this Enterprise-driven segment. Finisar is particularly exposed to this, much more so than its peers.

It is possible to see a scenario where Finisar grows 20% over the next year barring any macro meltdowns. It is tough to see how it grows only 10%.

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

| View | Upload your own

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 (EQIX), Level3 (LVLT), Akamai (AKAM), IBM (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 (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 (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 (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 Though?

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 (INTC) and Opnext (OPXT), and negative for suppliers attempting to take share at Cicso such as Finisar (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 mo
nopsony. And it is here that Finisar and Avago have large structural advantages over the competition.

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

This decision by Google, while small in terms of units purchased, is enormous in terms of the disruptive impact it should have on 10GbE switching equipment providers and their component supply chains. It is as if a MACHO just arrived in the Enterprise networking business and the orbits of the existing satellites have begun to shift without observers knowing why – until now.

We were watching shipments of SFP+ components for 10GbE in the market but simply couldn’t account for their end destination – sort of an optical component dark matter problem. After a great deal of investigation we have reached the following opinion:

Through conversations with multiple carrier, equipment, and component industry sources we have confirmed that Google has designed, built, and deployed homebrewed 10GbE switches for providing server interconnect within their data centers. This is very similar to Google’s efforts to build its own server computers (excellent article here). Google realized that because its computing needs were very specific, it could design and build computers that were cheaper and lower power than off the shelf alternatives. The decision to do so had a profound impact on server architecture and influenced the market’s move to lower power density solutions that Sun (JAVA) , Intel (INTC) and AMD (AMD) now embrace.

It now appears that the process Google trail blazed in the server computing market will repeat itself in the enterprise switching market. Given the relative dearth of low-cost 10GbE switching solutions, it isn’t surprising to see Google revisit this approach.

We believe Google based their current switch design on Broadcom’s (BRCM) 20-port 10GE switch silicon (BCM56800) and SFP+ based interconnect. It is likely that Broadcom’s 10GbE PHY is also being employed. This would be a repeat of the same winner-take-all scenario that played out in 1GbE interconnect. Vendors of standalone 10GbE PHY silicon ( AMCC (AMCC), VTSS (VTSS.PK), Netlogic/Aeluros (NETL) ) should take close note. Broadcom’s role in hollowing out equipment is something we previously profiled in depth (see Cisco’s Fear of a Broadcom Planet).

What is interesting about Google’s approach is that it has eschewed traditional 10GBASE optical standards and instead adopted off-standard solutions that better suit its needs for time-to-market, power and port density, and cost. While Google makes use of the SFP+ cage format, it does not use the receive dispersion compensation (EDC) function typically associated with SFP+. Instead Google is looking to employ a combination of twinax cabling for short reach (<10m) intra-rack cabling and a motley 850nm SR-like standard. Off the shelf SR optical modules appear to work well up to 100m over without receive equalization. Ironically, Finisar (FNSR) proposed such a solution several years ago.

This non-standard and very low cost optical format should prove just as attractive to other datacenter customers. Given the delays in deploying production grade EDC solutions it is possible vendors will move forward with an SFP+ SR standard without EDC. This would be a boon to suppliers of SR based SFP+ modules such as Finisar and Avago as adoption of the SFP+ standard will accelerate faster once decoupled from the complexity and cost of EDC. (see Five Misconceptions About the 10G Optical Market)

It is difficult to determine the precise amount of components Google is purchasing. Google is believed to have in excess of 500,000 servers. Based on shipments of 10G SFP+ modules, our best guess puts Google’s current usage at approximately 5k ports of 10GbE a month. This would include both server based SFP interconnect as well as the switches themselves. While the number is low, it is Google’s implementation and motivation for building their own switches that will resonate through the equipment and component industries.

At this time, other purveyors of large data centers like Yahoo, Microsoft, and Equinix do not appear to be following the same aggressive path with SFP+ optics. This is likely to change as new low cost per port 10GbE equipment from Arastra, Woven, Force10, Cisco (CSCO), and Juniper (JNPR) come into production that make use of the new format.

To us, it is Arastra that is the most interesting company in the context of Google’s decision. Arastra is building a system that closely matches what Google appears to be doing in secret. A picture of Arastra’s 7148S system with 48x 10GbE ports is below.

Arastra presents the pseudo-IEEE standard 10GBASE-CR which appears to match the twinax approach Google is taking. Furthermore, Arastra was founded and funded by Andy Bechtolsheim, Chief Architect at Sun Microsystems and who is closely tied to Eric Schmidt, the CEO of Google and an ex-Sun executive. Andy Bechtolsheim was also one of the first investors in Google. With these connections, Arastra may be the commercialization of Google’s technology and the ultimate supplier to Google itself.

Through our investigative research, Nyquist Capital reached the conclusion  that 12 months ago Google took a look at the state of the art in 10GE switching equipment and decided that it could do better. The reasons behind this decision will have a large impact on how the small but rapidly growing 10GbE equipment and component market evolves.

Author holds positions in Broadcom, Vitesse, Finisar and AMCC.

Equinix provides data centers for colocation and interconnect. They build their own or lease a property from companies like Digital Realty Trust (DLR)  and equip it with connectivity and additional infrastructure. Then they sublet the space to companies looking for data center space – everyone from Carriers to CDN’s to Web 2.0 service providers. Google, Yahoo and a few others build their own mega data centers – for everyone else there is Equinix. Lane used an airline analogy; they are not a carrier but more like an airport where various carriers meet to exchange passengers.

Profile of a large Equinix data center:

• Supports up to 30 Megawatts of power
• 250k square feet of floor space
• 40% of this space is consumed by support infrastructure and cannot be leased to datacenter tenants.
• 200km of inside fiber plant
• 7-8 dark fiber providers connected to the building with 144, 432, or 864 fibers each.

Lane indicated that demand for optical capacity was surging and the backbone being ‘refreshed’ with higher speed technology, except with a higher focus on cost. The metric Equinix uses is Bitmiles, defined as the cost of sending a bit a one mile. This is identical to the speed*distance/cost concept I like to use but Bitmiles is a much better word.

Equinix data centers face the same problem as carriers – when you exceed the capacity of a router chassis (or the square footage of a datacenter) the only option is to mesh chassis together. Equinix is doing this in a metro area using dark fiber from providers like AboveNet (ABVT.pk) and multiple 10G wavelengths to virtualize datacenter capacity across a metro area. They call this IBXLink, and it allows customers to place servers in separate data centers but have it appear they are locally connected. This is only possible if optical transport costs can be minimized.

Lane mentioned two approaches he felt were successfully addressing the bitmile problem.

1. Build your own WDM transport network by putting long haul optical transponders right on the router and installing standalone passive WDM filters. The resulting dirt-cheap optical network is completely passive except for EDFAs. Equinix customers will purchase optical modules such as these from Finisar (FNSR) and insert them into switching equipment. This can yield savings of 60% when compared with buying separate transport equipment, but is not manageable and requires all failure protection to be done in the router. My opinion – it’s a cheap hack but sometimes that is all one needs.

2. Stop spending money on QOS when 90% of your traffic is best effort. Move this traffic to a secondary network using best effort Ethernet L2 switching at 1/10 the per port cost when compared with high end routers. My opinion – this is the future.

Option one isn’t a new approach but the combination of pluggable optics with embedded OAM&P functionality (flexible SONET/OTN/GE provisioning) and new ultra-cheap datacenter switches like those made from Force10 is a truly disruptive solution that combines elements of both options. I believe this solution will be very attractive once this low cost hardware can implement emerging Metro Ethernet Forum standards.

While option one is good from a cost perspective at some point network manageability and protection requirements require a standalone transport solution. To the degree Equinix is focused on driving down transport costs, the fact that they are a major customer of Infinera (INFN) lends credibility to Infinera’s claims of having a lower cost transport solution.

Author owns positions in Abovenet and Finisar.

Video is Driving 10GbE

This is by far the most over-used and misdirected belief and causes me physical pain when I hear it. Yes, video is playing a major role in the expansion of WDM transport networks. Yes, most of these new links are 10G. But much more growth is coming from the datacenter as bladeservers and computing infrastructure transition to 10GbE. Companies like Broadcom are driving down the cost of putting 10GbE in servers, and subsequently will drive demand for 10GbE switching equipment. Other trends such as re-using the 10GbE standard for datacenter storage interconnect amplify this trend.

At best, 100k new 10GbE connections will be deployed in the core network in 2007. Compare that with the 400k or so modules Cisco alone will sell in the same timeframe. In 2008 the gap grows much larger.

But everybody understands YouTube, so video remains the lip-synching poster boy.

10G is One Market

Few bother to drill down into the innards of module types and specifications to understand product mix, and are quick to dismiss the alphabet soup of module types and laser reach specifications. This is a huge mistake as the majority of unit volume gain in the next 5 years will come in a narrow segment of product and reach types.

The 10G optical market is really several different markets with little or no relationship to each other in terms of cost, market demand, competitive pressure, and growth. Little things, like the tendency for enterprises to deploy OM-3 fiber have an enormous impact on product mix.

Incumbent 10G Suppliers Will Benefit

Some existing suppliers will do well, but the mistaken view that 10G is one market drives investors to believe all companies supplying this market will benefit.  To borrow a much abused term, the distribution of growth in the 10G market is ‘lumpy’.

Opnext (OPXT) makes great hay about the importance of the 10G transition to their business and justifiably so given they are top supplier to Cisco for all types of 10G modules. While it is impressive that Opnext (as well as Intel (INTC)) supply the bulk of the volume today, it isn’t clear that they have adapted their supply chain for the demands of tomorrow.

My belief is virtually all unit volume growth will be in the low-cost, short-reach segments of the market, a market characterized by brutal price competition and 20-30% gross margins. Vertically integrated companies will be positioned best when volume ramps. Opnext is a somewhat vertically integrated manufacturer of long wavelength modules but heavily outsources both components and manufacturing of short reach modules.

It would not surprise me to see Opnext acquire a VCSEL manufacturer itself to remain competitive as the short reach market moves to higher volumes. I also believe this was the primary justification for JDS Uniphase’s (JDSU) acquisition of Picolight. (see “Why JDSU Bought Picolight“).

Such an acquisition still leaves both companies with a cost structure unsuitable to high volume commodity production.

I believe Finisar (FNSR) is the best example of a company well adapted to such a commodity environment as they are by far the most vertically integrated manufacturer of these types of components.

It will be interesting to see how all companies adjust in the volume shift in the 10G market. Perhaps Opnext decides to focus exclusively on long wavelength products, like they already have at 2.5G.

SFP+ is a key growth driver

SFP+ is a new low-cost 10GbE form factor and is a hot buzzword. It will indeed have a major impact on the market and is the key battleground in the competition between optics and copper interconnect. Industry insider consensus is SFP+ will not be ready for prime time in 2008 and I agree.

This is one trend where I admit I could be wrong as Cisco (CSCO) could change the whole equation quite abruptly. Cisco itself indicates only a small fraction of the modules it buys in 2008 will be SFP+, but doubts linger in my mind.

As readers know, I believe Cisco derives enormous profits from reselling optical modules. The transition to SFP+ is critical to Cisco for two reasons.

1. Lower cost modules mean lower cost 10GbE ports. Driving down 10GbE port costs is the most important vector for driving 10GbE adoption. Cisco must leverage their hegemony in 1GbE into 10GbE and not allow others to gain share. If they can drive costs better than anyone else they will capture the market share.
2. Cisco will make significantly more money reselling SFP+ modules than the existing X2 modules. Pulling in this transition just one quarter drops $25m of pure profit right to Cisco’s bottom line.

I am nervous betting against Cisco’s desire to make money and retain hegemony.

Copper (10GBase-T) isn’t a factor this time

Jury is still out on this one. One thing for sure- it shouldn’t be a factor until 2011 or so and faces significant technology headwinds. 1GbE optical component growth stalled in late 2004 as it could not match the per port costs of Gigabit Ethernet over copper. We shall see if this time is different.

Author is long Finisar.

… and I vow to torture a small animal in my office every time I hear or read the words “Video” and “Explosion” used in the same sentence. You, your Marcom group,  and your conscience have been forewarned. (Just Kidding.)

Vendors express their caution the same way - “We see this as a commodity market and we aren’t commodity suppliers“. I heard this statement directly from JDSU (JDSU) and several other module vendors. Vendors looked self assured when they said it. Sell side analysts love to hear it.

The problem is that most of the optical component and module market will ultimately be commodities, and if a supplier isn’t building commodities they won’t be building much of anything.

Vendors communicating this message have a noble goal; they have no wish to repeat the over-investment sins of the past. In the year 2000 there were over 30 companies building optical modules; it would be a comical understatement to say the market was oversupplied. This memory triggers a flight response in incumbent module suppliers that encourages them to run from any market that looks marginally profitable or highly competitive. The FTTH market is a great example.

Unfortunately for them, any technology market that is big is also commoditized and highly competitive. The communication semiconductor company that figured this out first was Broadcom ::(“BRCM”)::, which won’t even touch a market that isn’t $500M.

The debate about the FTTH market isn’t whether it will be big but whether it will be profitable. PON is becoming the global access technology of choice for new construction. (self quoted from “FTTH in China Part I“)

Consider the numbers in China alone: the massive migration of labor to urban areas is creating the biggest greenfield telecom installation opportunity in history. Three hundred million Chinese will migrate to the cities in the next 15 years -the equivalent of creating a Los Angeles/Orange County/San Diego urban each year until 2021.

Any component market this big is by definition is a commodity market. Marginal producers that cannot cover large fixed costs are unprofitable, suppliers with scale and leverage on such costs are very profitable. Therefore, only vertically integrated market share leaders have any hope of profitability. The trick is for such supplier to arrive at the market “fastest with the mostest“.

Bookham (BKHM) attempted the same strategy in higher end telecom products and met with disaster. I outlined the risks in combining vertical integration with niche products a year ago (see last paragraphs of “Bookham, China, and the Optical Component Market“). I still stand by my assessment that a vertically integrated strategy makes sense for high volume, commodity module markets.

From Bookham, China, and the Optical Component Market (May 2006)

Finisar’s decision to introduce a FTTH product brings them into direct competition with Luminent (MRVC) and Fiberxon, two companies that once merged will form the biggest incumbent supplier of optical components for the FTTH market.

Luminent is a big supplier into Verizon’s B-PON deployments, and Fiberxon is an on-again/off-again supplier into NTT’s GE-PON deployments (discussion of these technologies can be found here). The biggest competition to-date for Luminent/Fiberxon has been the propensity for FTTH equipment suppliers to design and build their own modules at contract manufacturers. If (an if too big for me) the merger is successful, the resulting vertical integration will make Luminent/Fiberxon a force to be reckoned with.

The product Finisar announced is for G-PON, which Verizon will begin deploying this year as part of it’s transition from B-PON. Finisar is clearly trying to capitalize on the market breakpoint created by this transition.

Ultimately we feel GE-PON volume will outstrip G-PON volume based on our assumption it will be the technology of choice in Asia. According to Finisar, they are not betting on G-PON vs. GE-PON. They simply see G-PON as a good entry point for FTTH optics, given that few domestic suppliers exist to meet Verizon’s demand.

I believe this is only a first step, as Finisar appears to understand the importance of being the low-cost supplier (not necessarily low price) and unlike other vendors, embraces the idea of supplying commodities. This attitude will be required for success in not just the FTTH market, but the optics market in general.

Author is long Finisar

Here’s a top 10 list of my most notable observations from the Executive Forum at the Optical Fiber Conference in Anaheim last Monday.

1. When the Carrier panelists (Verizon, AT&T, BT) spoke of SONET/SDH they used the past tense. “When we used to build a SONET/SDH ring”. They appear to have subconsciously moved on.
2. According to Ryan Limaye from Goldman Sachs, Sanford Bernstein issued a report analyzing what would happen to the Telcos if they became a dumb pipe. The result? Much smaller but more financially efficient companies with a better return on equity. All of the carriers with the exception of British Telecom were not open to the idea of being a dumb pipe.
3. Observation: Equipment guys are asking for 40Gb/s components, and component vendors are giving them the finger. The fact that component vendors no longer allow equipment vendors to outsource R&D with a low ROI is a very positive development for this business. People are finally saying no.
4. 40Gb/s demand pressure is from carriers who deployed the Cisco CRS-1 router and need something to hook it up to. Stephen Carlton from Fujitsu kicks in that 40G muxponders make up the other 50% of demand. Many speculate 40G will be bypassed altogether in favor of 100Gb/s Ethernet using new modulation schemes.
5. Jerry Rawls from Finisar (FNSR) - “It is impossible to deliver the level of R&D expected by customers given current margin levels”. “Custom Tweaked Requirements are hard coded into the Telecom psyche and may be impossible to remove”.
6. Fariba Danesh from Avago (private) - ”Finisar pricing is making things difficult for us” (I didn’t get a precise quote… but this definitely was the jist).
7. Jo Major from Avanex (AVNX) – “Huawei still tends to buy at the component level.” Something I’ve covered in depth (see Dr. Strangelove, Or: How I learned to stop worrying and love Huawei)
8. Mike Nishiguchi from ExceLight – “Optical Modules are footprint compatible but the components that go into them are not. Why? We should think about this.” On outsourcing (heavily paraphrased): “The Japanese are not good at giving people titles and job descriptions. This is because they are not good at partitioning responsibility. And this is why I believe Japanese companies are not good at outsourcing their manufacturing”.
9. Gary Wiseman from Intel (INTC) Promises $150 SFP+ module in 2008. Claims 10G-BaseT will be delayed due to 2.5us latency, 6W of power, and new cabling. He clearly wants to keep copper interconnect out of 10Gb/s.
10. Stephen Carlton from Fujitsu (FJTSY) – “Don’t design your network for Video because much bigger drivers exist in the near future. Japan is trailblazing these applications with a cashless society, hyper-mobility, and other application innovation. Their greatest lead isn’t in FTTH, it is in application innovation.” Example: Take a photo of your sushi and your mobile will tell you when it was caught and what boat it came from. Stephen’s comments were unique and a refreshing break from the “Video Broadband Explosion” cited again and again by many talking heads.

Many of these quotes are paraphrased though I feel I captured the intent of the speaker. If I did not, please speak up. Some of these topics have follow up articles that I may release publicly.

Full disclosure: I am long Finisar.

… The crazy thing is Corning, in ’99, had offered Nortel $100B in cash to buy this division. They turned it down because they thought it was not enough money. Now, in two quarters, their sales dropped from $1.4B to $23M. It was a crash that nobody could manage their way out of, all you could do was try to unload it, get rid of the division and make somebody else deal with it.

I believe Jerry mispoke - the deal was publicly discussed to be a stock swap where Corning would tender shares to Nortel, and it was in the summer of 2000. Even in the most alternative reality universe I don’t think a company could find $100B in cash to buy a product line generating $1.4B in revenue. The WSJ covered this at the time but the link is dead. Lightreading archives have some commentary.

Regardless, it is a great example of the craziness that surrounded the industry at the time. Bookham (BKHM) eventually swept in and assumed operations of the Nortel division. Today everything that was once Nortel is now completely gone. $100B to zero.

The interview with Jerry Rawls is very long, very detailed, and very good. Start here. It appears that Frank Levinson is answering comments as well.

Flat Revenues

The flat revenue guidance for FQ407 of $104-$110M was particularly disappointing after a flat FQ307. This revenue plateau is entirely due to 11% quarter over quarter reductions in multimode LAN/SAN revenue. Other product areas made up for the shortfall resulting in flat top line revenues.

Sales of LAN/SAN 850nm VCSEL based products dropped from $62.6M in FQ207 to an expected $49.5M in FQ407, a reduction of $13M in revenue.

Finisar is the leading provider of multi mode optical modules in the world. This is a very big drop, something that the financial community isn’t questioning sufficiently.

The culprit, as explained to me by Finisar, was an inventory correction tied to 4G Fibre Channel SFP products. At one point these modules were on allocation and the company witnessed a classic case where customers double order in order to assure a large allocation of scare product.

The sheer magnitude of the shortfall ($13M) seems awful large to be tied to such a narrow product area, though I have received assurances from the company this is the case. Is this inventory correction prolonged by a move to 8G Fibre Channel? What else is at work here? Comments and thoughts are welcome.

Metro and Telecom Revenue Growth

The strength in Metro modules, primarily high-end tunable transceivers, is very notable. This is not where I expect Finisar to take share since  their competitive advantages are in multi mode LAN/SAN market. This new strength comes not just from customers shifting away from 300-pin MSA modules, as well as taking share from companies like Optium (OPTM), (AVNX) and Intel (INTC).

The company mentioned component supply chain constraints as the reason they could not deliver sufficient 10G modules to meet demand. A little known fact is that Finisar, unlike all other module makers, has taken the additional step of vertically integrating their analog IC requirements. Instead of purchasing components from Mindspeed (MSPD), AMCC (AMCC) or Vitesse (VTSS.pk) Finisar designs and fabs their own laser drivers, clock and data recovery, transimpedence amps, etc. This is not an easy thing to do and I suspect was the cause of their 10G hiccups.

This in-house IC expertise makes them the most vertically integrated module maker in the world. Customers like Cisco certainly notice and appreciate the future pricing benefits this will bring regardless of short term problems.

$1M in Cisco X2 module revenue

$1MM in X2 module revenue at Cisco (CSCO) is a drop in the bucket. Cisco purchases about $40M in 10GE modules on a quarterly basis. This is not negative for Finisar, it’s an an indicator that the ramp at Cisco has lots of runway.

Wall St. does not understand the architectural transformations underway at Cisco and how this will impact the module supply chain. While all analysts agree this is positive for Finisar our internal research indicates they are underestimating the revenue impact.

 Author is long Finisar