FOOL ON THE HILL
Comparing Optics and Dot-coms

Comparing optical networking companies and dot-coms doesn't make sense since optics companies have real revenues, make real products, and are even generating profits, right? Wrong. Formulating a good business model is just one tiny step on a long journey companies must make to reward shareholders.

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By Richard McCaffery (TMF Gibson)
November 9, 2000

What do optical networking and dot-com stocks have in common?

Nothing, say industry analysts and eager investors who laugh off the comparison. It's ridiculous. Optical networking start-ups -- as hot in the initial public offering market this year as dot-coms were in 1998 -- have real business models. They manufacture real products in high demand, are loaded with intellectual capital in the form of experienced engineers, and are helping to build out a 21st century communications network that will take more than a decade to construct.

The optical components industry alone is expected to grow to $23 billion by 2003 from $6.6 billion in 1999, according to telecom research firm RHK.

In the sense that many of the dot-com companies were phony businesses and a lot of the optics companies aren't, the comparison doesn't make much sense. But in terms of risk, I see plenty of similarities the average investor can learn from. For starters, what's the difference between investing in a lousy company and paying way too much for a decent one? It doesn't matter which door you open in this scenario, either way you lose to the market.

What's really dangerous, however, is discounting the risk inherent in the optics industry simply because these companies look so much better than the dot-coms.

They do look better. They have proprietary technology, revenues, some even have profits, but the race is just getting started. Don't get fooled into thinking these companies are a slam-dunk because of a too-easy comparison with dot-coms. That's what behavioral finance folks would call a contrast bias: Optics companies look way better than dot-coms, which makes us view them more favorably than perhaps we should. Early profits and whiz-bang technology doesn't mean these companies will be able to earn a satisfactory long-term return for investors. Most probably won't.

The bottom line is that many of these companies have only cleared the first hurdle, and yet the applause is deafening. Now they face the same serious challenges all new businesses face. It won't be easy to develop and sustain competitive advantages, not in an environment where technology changes fast, execution risks are high, and cash is easy to find.

In fact, the optics stocks may be riskier for the investor than the dot-coms in two significant ways. First, optics technology is seriously complex. If you're an engineer, work in the telecom industry, or have an affinity for optics, great. You've got a useful edge. It will be an uphill climb for many, however, to get a handle on the important technologies, and will require much more than a casual interest.

By comparison, the technology for the dot-coms was pretty straightforward, and you could figure out how well a company was doing by shopping on its website. There were certainly challenges in assessing the business models, but basically these companies were retailers hoping to grow rapidly and leverage lower fixed costs.

Second -- and here's the real pitfall -- the optics space is dangerous because it makes so much sense. Ben Graham wrote about this in The Intelligent Investor. Investors get done in more often by good ideas than bad ones, since it's easier to swallow a convincing case. Optics companies will help carriers lower their costs by constructing more efficient networks; they have high barriers to entry given the complexity of technology; and carriers must upgrade to meet the bandwidth demands of customers. This sounds great. It sounds inevitable.

All of it is true and doesn't change the fact that most optics start-ups will fail or get bought out for one of a dozen normal business reasons: technology that gets marginalized by a better mousetrap, inability to manufacture products quickly and at low enough costs to maintain good margins, uneven spending from service providers, poor execution, a weaker economy, or less industry buzz that makes it harder for unprofitable companies to raise cash.

Don't get me wrong. It's a fascinating space with real potential. Companies such as JDS Uniphase (Nasdaq: JDSU), Corning (NYSE: GLW), and Ciena (Nasdaq: CIEN) look like the real deal, generating fast-growing revenues and a profit on at least a pro forma basis. Aside from the price issues -- which I wouldn't ignore for a second -- a handful of businesses look poised to grow into telecom powerhouses.

What's useful to remember in the optics/dot-com comparison is that both industries are emerging, a state of affairs that makes investing very difficult. Why not wait a little -- for the venture capital crowd to get choosier (lots of cash makes everybody look like winners), for the lock-up periods in newly issued companies to expire, for a few telecom carriers to pull back spending, for the group to really get tested by a downturn -- before jumping in headlong?

You have plenty of time. The market creates and recreates opportunities for patient investors.