Brave New World of Optical Networking[Fool on the Hill] February 8, 2000

An Investment Opinion

Brave New World of Optical Networking

By Richard McCaffery (TMF Gibson)
February 8, 2000

Part of what makes investing in technology companies challenging -- and dangerous -- is rapid change across the industry. It's daunting, fraught with risk, and not for everybody, but I don't think investors should avoid technology companies just because they aren't engineers. That's bunk. Go where your interests lie and fight to get up to speed.

Consider Microsoft (Nasdaq: MSFT). Ten years ago almost nobody knew the function of an operating system, or understood the amazing competitive edge Bill Gates grabbed by quickly establishing Windows as the standard. Or look at Cisco (Nasdaq: CSCO). Who understood the power of a computer network five years ago, or guessed the vital role routers would play in shaping the development of the Internet?

Not many of us, but by reading, studying, and bending our minds a bit we can obtain a working knowledge of the technology that's driving this fantastic world economy. That doesn't make the average investor an expert, but in the case of a Microsoft or a Cisco we can learn enough to participate Foolishly, and that's the goal.

That brings us to the latest phenomenon, broadband technology. A year ago, very few of us knew what it was, or even understood the concept of bandwidth. Roughly speaking, bandwidth is the amount of data that can be transmitted across a communications network per unit of time, generally per second. Broadband is just a description of a system that can transmit large amounts of data, the kind you'd need to watch a feature-length movie on your PC, or even to open a graphics-heavy file.

Now, thanks to the spectacular rise of JDS Uniphase (Nasdaq: JDSU), we're all talking about the latest in broadband technology, optical networking, which greatly increases the capacity of communications networks. In other words, it increases the bandwidth.

In the last year, shareholders have watched JDS soar from $18 5/8 a share to $215 13/16, a 1,075% climb. I have no idea how to value this company, which makes components and modules that help increase bandwidth. I will say it looks like the real deal. The fiber optics market generated about $5.5 billion in 1999 and is expected to grow to $21.3 billion in 2003. JDS, because of its deep management, dominant market position, integration abilities, and valuable stock currency looks ready to capture a nice portion of the growth.

So, is it over? In other words, is there anything around the corner in the red-hot field of optical networking? Plenty. Last year was all about hardware and increasing the capacity of networks with gizmos like multiplexers, pump lasers, and couplers. This year it's all about software, and managing network traffic. Remember, you can only lay so much fiber. The other way to speed traffic is to better manage the flow, and there are a crop of exciting new companies racing to do just that.

First, however, an example of what I mean by managing network traffic. Current networks are static, which means they aren't very flexible. If you could watch a map of network traffic in Washington, D.C. you'd see usage skyrocket at about eight in the morning, when everybody gets to work. Demand is high all day then falls off sharply around five. At night, network engineers would like to shift that excess capacity from the city to the suburbs, but they can't because the networks are inflexible. As a result, capacity in the city lies unused while Web users at home squeeze through bottlenecks.

Not for much longer. Managing network traffic is the next big trend in optical networking, according to Scott Clavenna, principal analyst at Pioneer Consulting, a Cambridge, Massachusetts market research firm that focuses on broadband technology. How big an opportunity awaits the best companies? Consider that just $5 million worth of optical switching equipment was shipped last year and that it came entirely from one vendor -- privately held Tellium of Oceanport, New Jersey. By 2004 the market will have increased to $14 billion and it shows no sign of slowing down, Clavenna said.

The Internet, of course, is what's driving the big network companies to invest in optical switching technology. But there are also pressing cost issues. With one rack of optical switching equipment a carrier can accomplish a job that used to require 20 racks of standard gear, Clavenna said. Companies recognize an immediate 40% cost savings, and overtime the savings approach 70%, he said.

Pioneer Consulting divides the optical switching market into two groups, since each requires a different skill set. Clavenna looks at vendors that focus on optical core equipment -- the gear installed on long distance lines operated by companies like AT&T (NYSE: T); and the vendors that focus on optical edge equipment, the gear for use in local areas and metropolitan markets. "These are the two areas we're most excited about," he said.

Some of these companies you've heard of and others you probably haven't. At the optical core are players like Ciena (Nasdaq: CIEN), Sycamore (Nasdaq: SCMR), Tellium, Cisco, though its purchase of Monterey Networks, privately held Corvis, and Nortel (Nasdaq: NT), through its purchase of Qtera Corp. At the optical edge are companies like Chromatis Networks, Alidian Networks, Astral Point Communications, CiDRA Corp., and a slew of other start ups.

Clavenna stressed that managing network traffic requires great software, not simply hardware and components. What this means for the winners is that their products should have a sustainable competitive advantage, one based on the strength of their software code rather than hardware that might be more easily reproduced.

Of course, great technologies don't reward shareholders, great companies do. Find ones with strong legs and big lungs, do the research, weigh the risk, and have a blast.

Finally, there's a jackpot of information available for optical networking junkies. The industry's premier trade show, the Optical Fiber Communication conference, runs from March 5 to March 10 in Baltimore, Maryland. The exhibition floor will be jammed with companies rolling out products.

I'm also a big believer in trade newspapers, industry websites, and research groups. A few sites that offer news and technology on the optical networking industry include the Publications Resource Group, the Optical Society of America, and Light Reading. Want to know more about the godfather of optical networking, check out this Light Reading interview with Wu-Fu Chen, who's chairman of the board at nine optical networking startups.

Have a great day.