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Cashing in on the Optics Opportunity

 


By Hal Plotkin
Silicon Valley Correspondent

If you are still kicking yourself for not buying Intel Corp. {INTC} in the early ‘80s or Cisco Systems Inc. {CSCO} a decade later, you might want to take a very close look at optical stocks right now.

Even with record valuations for some companies, such as CIENA Corp. {CIEN} and Corning Inc. {GLW}, analysts say that it isn’t too late to get in on what may be at least a five-year bull run.

“We’re nowhere near the end of this,” says Jim Slaby, senior industry analyst at the Giga Information Group in Cambridge, Mass.

Like other analysts, Slaby says that the demand for optical components and systems is far outstripping the supply.

Slaby isn’t just talking about replacing the existing telecommunications infrastructure, which is a huge market opportunity all by itself. He is also talking about the need to build out an additional 10 to 100 times that capacity, maybe even more, in totally new bandwidth to accommodate the growth of the Internet, voice traffic, data, application service providers, video and everything else.

“We’re going to need oceans of new bandwidth over the next five years, and there is just no way that can happen without the optical companies,” Slaby says.

The overall market for fiber-optic components is projected to grow to $21.3 billion by 2003, up from last year’s $5.5 billion. It could mushroom to as much as $150 billion by 2005, according to a recent research report published by Donaldson Lufkin Jenrette analyst Hasan Iman.

The analysts say Wednesday’s highly successful initial public offering by
optical-components maker Oplink Communications Inc. {OPLK} and recent merger activity in the sector are additional confirmation that long-term trends continue to work in favor of firms building next-generation optical-based telecom networks.

The stock of San Jose, California-based Oplink Communications, which makes components for optical-telecom systems, began trading on Wednesday after pricing on Tuesday night at $18 a share, $6 above the high end of the price range originally targeted by the firm.

Oplink’s stock closed at 33.625 on Wednesday.

“The optical space is the next horizon for the development of telecommunications,” says Tom Valovic, research manager at International Data Corp., based in Framingham, Mass. “Optical is going to be the next big area for some time to come.”

“The Oplink IPO [was] almost certain to be a monster,” Slaby says. “The Street seems to have an insatiable appetite for all things optical, and I don’t think the frenzy is unwarranted.”

In fact, it is hard to find any analysts, either industry or financial, who are negative on the optical sector, given the pressing need for increased communication bandwidth that can only be met with optical technology.

The advent of one of the optical industry’s newest technologies, called dense wave division multiplex {DWDM}, is particularly good news for growth-minded investors.

DWDM uses different colors of light to move considerably more data over a single fiber-optic line than was previously possible. The increased capacity of each fiber-optic line creates greater demand for the components needed to push data through those lines and to manage those data once they arrive at their destination.

“The point of all this is that as one part of the network gets built out it creates the need to build out the other parts of the network to the same speeds,” Slaby says.

The optical-components sector got a little spooked earlier this month after Sanford C. Bernstein & Co. analyst Paul Sagawa forecast a 3 percent decline in telecom spending on equipment next year, on the heels of growth of 31 percent this year.

But other analysts say there have been many warnings about similar potential spending slowdowns in the past that turned out to be inaccurate. What are missing from those projections, they say, are calculations of the costs involved if telecom carriers don’t spend heavily on the latest, fastest, most-powerful optics technologies.

Data traffic, and in particular the most sought-after traffic, will always find the fastest networks on which to travel, analysts says, just as water always finds its way downhill.

“There’s plenty of competition in telecommunications,” Slaby says. “If the big telcos don’t get it done, there are the competitive local carriers who are interested in the traffic. None of them can really afford to allow their networks to fall too behind, or they will lose customers.”

Buying into the newest and hottest optical IPO, however, such as Oplink, might not be the most-reliable way to participate in what is expected to be the sector’s considerable upside over the next few years.

Oplink has posted more than respectable revenue growth since its inception in 1996, seeing sales shoot up from $9 million in fiscal 1999 to more than $39 million in fiscal 2000, ended June 30.

But Oplink’s pre-IPO filing indicates the firm could face some hurdles as early as next year, when one of its biggest customers, Lucent Technologies Inc. {LU} is expected to curtail or even discontinue its purchases of a key Oplink product, which accounted for 28.3 percent of the firm’s revenue last year.

“Our dependence on a small number of customers may increase if the optical-components

industry and our target markets continue to consolidate,” the firm warned before going public.

As such, analysts who follow the sector say investors will probably get more-predictable results form more-established and dominant players such as CIENA and Corning, as well as Finisar Corp. {FNSR}, which is making headway with high-margin, low cost products that analysts say are in particularly high demand at this stage of the build out of optical networks.

Here’s a closer look at those three companies:

CIENA
Analysts say CIENA’s winning hand stems from the company’s success in bringing the newest high-margin optical-switching products based on DWDM technology to market ahead of competitor Nortel Networks Corp. {NT}, as well as the company’s success in opening up sales opportunities in metropolitan markets both foreign and domestic.

CIENA’s previous focus was primarily on the long-haul carriers that were the first customers interested in the firm’s pioneering DWDM technology.

CIENA inked a much-talked about agreement late last month to sell its DWDM products to Korea Telecom Corp. in what is believed to be the largest Asian deployment of optical-transport systems for metropolitan-area networking to date.

Bill Choi, an analyst at PaineWebber in New York, has been pounding the table on CIENA’s stock for months now.

Choi set a new 12-month price target of 145 on the stock after the announcement of the recent deal with Korea Telecom and also reiterated his longstanding “buy” rating, which is his highest recommendation.

“The potential for CIENA’s market is really quite huge,” Choi says. “There’s really no way to measure it.”

Choi says CIENA continues to outpace competitors in the DWDM market. “You’re looking at competitors such as Nortel that are sold out for the rest of the year, and are now backlogging all orders for 2001,” he says. “CIENA has a much shorter lead time than Nortel, and in this market that is very significant.”

CIENA’s stock moved up sharply after news of the Korean deal, then fell back by about 10 percent on Tuesday as investors took profits. Choi says he expects to see the volatility continue, albeit along an upward trajectory.

“Everyone said it was at a high multiple back when it was at $80 a share, so it’s going to continue to fluctuate,” Choi says. “But I don’t think we’re going to see any real lasting declines until we see growth not accelerating anymore. And that is not what we’re seeing.”

“Look at what has happened to CIENA’s valuation throughout the year,” Slocum agrees. “It has continued to swell when others have not.”

On Monday, Slocum also tabbed CIENA as one of his top three current picks in the sector, along with Corning and Finisar. He sees CIENA’s stock moving up to his $250 target by early next year.

Corning
Last week, Merrill Lynch analysts Steven Fox and Thomas Astle reiterated their “long-term buy” rating and $400 12-month price target on Corning’s stock. The move came after the company announced an agreement to acquire 90 percent of Pirelli SpA’s interest in optical components and devices for $3.6 billion in cash. Merrill Lynch acted as a paid financial adviser to Pirelli in conjunction with the transaction.

“We think this acquisition will expand Corning’s offering in the photonics business nicely, adding even more to the growth potential of Corning in this already rapidly expanding area,” they wrote in a report.

Cisco Systems owns the other 10 percent of Pirelli’s optical business and has indicated its intention to retain those shares, which “should further enhance Corning’s developing relationship with Cisco,” the analysts wrote.

“We walked away from our recent meeting with Corning very bullish,” Fox says.

Kevin Slocum, an analyst at Wit SoundView, based in Bridgeport, Conn., likewise raised his forward-looking estimates for Corning earlier this month and reiterated his “strong buy” rating and 12-month price target of 450.

“The photonics sector has been and continues to be one of the bright spots,” Slocum says.

Slocum is particularly enthusiastic about one of Corning’s newest products, called LEAF, which embeds technology within fiber-optic lines that increase the functionality of those lines by eliminating some of the need for certain stand-alone components.

“These emerging solutions will be too small a factor to change business conditions next year,” Slocum wrote in a report. “But they will probably have an important impact in 2002.”

Finisar

Although lesser-known, Sunnyvale, Calif.-based Finisar is an especially fast-growing provider of optical components, testing devices and systems. The firm increased revenue by 96 percent during the fiscal first quarter ended July 30, as compared with the same quarter last year, with sales swelling to $27.2 million. Net income for the recent quarter also skyrocketed, growing to $3.2 million, more than double its level from the same period a year earlier.

“We think Finisar could trade into the $50 range,” over the next 12 months, Astle says.

Astle says Finisar is in exactly the right place at the right time, selling the low-cost, high-margin components needed to bring optical-transmission speeds closer to end users.

“The need now is to put optics into the big parts of the public network,” Astle says, pointing out that growth in that area is the next logical development, now that optical technologies have penetrated the network cores of the largest carriers.

Astle has a “near-term accumulate and long-term buy” rating on the stock.

Slocum agrees. His current earnings estimates leave him with a $57 price 12-month price target on Finisar’s stock, which he also rates “strong buy.”

“For longer-term players. the optics sector is where semiconductors were 20 years ago or where the Internet was five or 10 years ago,” Astle says. “There are going to be some companies that don’t make it, so you have to keep your eye on the emergence of new technologies, but when you have this kind of growth, we think the high valuation placed on some of these stocks is in many cases justified.”

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