Think optical components are things like glasses and contact lenses? Think again. This year, one of the hotter industries has been the companies that make components for fiber optic communications equipment. Chris Rugaber (TMF Chris) sat down recently to discuss the volatile, fast-growing industry with Fool analysts Richard McCaffery (TMF Gibson) and Paul Larson (TMF Parlay). The following is a transcript of their discussion.

TMF Chris: Thank you both for joining me today. Let's start off with the big picture. Both of you have written reports on optical networking components -- Richard in the Industry Focus 2001 and Paul in an issue of the Internet Report. So, what's the big deal? Why is this industry so hot now?

TMF Parlay: I'm not sure why the industry is hot NOW, but the underlying trend is thanks to the increased need for bandwidth. More Internet users mean more bandwidth is needed. Multiply this by the fact that each user is using applications that are larger in size (streaming music, etc.) and the need for bandwidth is growing exponentially. Optical networking is the way to provide exponential bandwidth.

TMF Gibson: No question it's a rapidly growing industry, that the old-world, copper-wire telecom infrastructure needs to be replaced and that optics is the way to go. Bandwidth is driving growth, as well as the carriers' need to cut costs. Internet traffic is roughly doubling every six months -- faster than Moore's Law [which says that computer microprocessor speed should double every 18 months].

TMF Chris: In fact, according to market researchers RHK Inc., the optical component market should grow from $6.6 billion in 1999 to $23 billion in 2003 as a result of these trends.

TMF Gibson: Investors need to be careful, however. Fast growth doesn't necessarily mean profitable companies with sustainable businesses. As exciting as the area is, investors should really be patient and choosy.

TMF Chris: True. Let's look at some of the companies in the optical components area. Leaders such as JDS Uniphase (Nasdaq: JDSU), Lucent (NYSE: LU), and Corning (NYSE: GLW): Where do they sit in the value chain?

TMF Gibson: JDS and Corning are component manufacturers. Lucent and Nortel Networks (NYSE: NT) make components, but their main business is optical systems.

TMF Parlay: Lucent and Nortel, while not pure optical plays, have significant "captive" components businesses. Both have signaled their interest in spinning these businesses off in the future, though Lucent is closer to getting it done.

TMF Gibson: I included a table in Industry Focus that depicts the optical components value chain, which we should take a look at: 

Testing, Measurement     Components     Subsystems     Systems     Service
and Automation                                         Vendors     Providers

Newport                  JDS Uniphase   Avanex         Ciena       Qwest
Veeco                    Corning        JDS Uniphase   Corvis      AT&T
Agilent                  Lucent                        Nortel      Verizon
Melles Griot                                           Lucent     

As you can see, component companies are toward the left of the value chain. What I like is that these vendors are at least one step removed from the systems vendors, whose technologies may or may not become obsolete. Ciena (Nasdaq: CIEN), for example, may make the best equipment in the world, for all I know. But will someone else come along tomorrow and build a better mousetrap, or will the industry standardize around some other product? It could happen. Either way, component makers sell products to everyone. That doesn't mean there isn't risk of product or technology obsolescence for component vendors, though the diversified vendors are in a pretty strong position.

TMF Chris: Interesting. Well, what's an example of an optical component?

TMF Gibson: Lasers are a basic component. A laser generates the optical signal. When thinking about components, which get very technical, remember that all these parts are designed to send, manage, and receive signals.

TMF Parlay: In the best-case scenario, they do this in the all-optical domain.

TMF Gibson: Exactly. That's the Holy Grail, though I think it's a ways off.

TMF Parlay: Agreed. Basically, the fewer times a signal has to go from being an electrical pulse to a light signal and back again, the better (and faster).

TMF Gibson: Right. Optical to electrical to optical transitions, which optical switches often have to make, are costly and hard to manage.

TMF Chris: What other factors should investors consider about the optical component industry?

TMF Parlay: I think one significant factor is that the component companies may have a competitive advantage in terms of technology. Fiber optics is a very complex field, and it is very hard to just run out and build a duplicate business. Moreover, the labor field for experienced engineers and physicists is quite limited. This means the barriers to entry are quite high, which is good for the existing companies.

TMF Gibson: I agree with Paul, but remember there are literally hundreds of start-ups and they would all argue they have some competitive advantage -- better technology, smarter people, and so forth.

TMF Parlay: Right. That's one of the reasons why it is perhaps better to stick with the established firms.

TMF Chris: OK, we talked about the growth curve ahead. What about some of the risks of investing in this industry? Richard, you talk about the "four flags" in your report.

TMF Gibson: Yes, the more I looked into the industry the more hurdles I saw for the average investor. Briefly, we have four drawbacks: Optics is very technical, products change rapidly, prices need to keep falling, and the companies have very high valuations.

TMF Chris: OK. What do you mean by prices falling? Could you expand on that? We're talking prices of the components falling?

TMF Parlay: Yes, it's related to the fact that optical manufacturing is antiquated. Many delicate components are still built by hand, which is amazing to me. Building by hand is obviously not cheap or efficient. Imagine if Intel (Nasdaq: INTC) built its processors by hand!

TMF Chris: Do you expect that to change soon?

TMF Gibson: It's changing, but I don't really know how fast the industry will scale.

TMF Chris: Right. Is this what you were talking about in your report when you addressed automation?

TMF Gibson: Yes. It has to happen and companies like Newport (Nasdaq: NEWP) are proving, in my opinion, that the industry can scale. There's opportunity there, but also high risk.

TMF Chris: So, getting back to price declines, are we saying that component prices will decline, and to combat this the component companies will need to automate their manufacturing?

TMF Parlay: Exactly.

TMF Gibson: I think about the pricing dynamic in two ways. First, prices must fall for carriers to afford fiber networks, to push them closer to customers. Second, manufacturers must automate to improve yields and enable prices to fall. It's all related.

TMF Chris: So, how will the talk from Lucent and Nortel (it's more than talk for Lucent) about spinning off their component divisions affect this industry?

TMF Parlay: It creates both opportunities and risks. Opportunity because Lucent and Nortel will be free to "shop around" and won't be limited to buying components made in-house. Risks because the competition for components will increase once these businesses are freed. Other fiber systems makers would be able to buy from the spun-off Nortel and Lucent divisions without fear of helping the competition.

TMF Chris: Corning and JDSU were up yesterday, in part due to an announcement by Corning that it will make its fourth-quarter and full-year numbers. How should investors think about the valuation of these companies? They're pretty richly valued right now.

TMF Parlay: They're richly valued companies because there is a rich opportunity ahead for them. Will the growth be enough to justify the valuations? That's the million-dollar question that I don't think anyone knows the exact answer to.

TMF Gibson: I'd say I like the position broadly diversified components makers have. My dilemma is a Dr. Jekyll/Mr. Hyde thing. For example, JDS really looks like a marvelous company with a great future. Mr. Hyde loves that potential growth and product might. But Dr. Jekyll has a hard time justifying a $62 billion market cap for a firm with $2 billion in sales.

TMF Chris: One last question. Richard, it sounds like in addition to the component companies like JDS Uniphase, that you think the testing and automation companies are worth a look. What are some of those?

TMF Gibson: Agilent (NYSE: A) makes testing and measurement equipment, as well as other components. Newport makes automation and testing gear. I like the companies farther upstream, on the left of that table above.

TMF Chris: Paul, any closing thoughts for investors interested in this sector?

TMF Parlay: I'd say doing your homework is extremely important in this industry. The technology is complex, so the hurdles to understanding are higher than normal.

TMF Chris: Great. Thanks a bunch!