When I think of companies that have the brightest growth prospects over both the short and long term, I think of the fiber optics industry and the companies most likely to benefit from its potential growth. The key to this growth? Our entire telecom infrastructure is being upgraded.
Instead of moving electrons over copper wires, more and more information is moving in the form of light over fiber optic cables. The demand for fiber optic equipment is growing at incredible rates, as network traffic doubles at least once a year. We'll ultimately hit a point where all information is moved on glass.
In our portfolio, we like to invest in companies with expanding possibilities. It shouldn't be surprising to learn we've invested in two companies with an opportunity to benefit from the future growth of this sector: Cisco Systems (Nasdaq: CSCO) and JDS Uniphase (Nasdaq: JDSU). This doesn't mean, however, that we've chosen to invest in competitors. JDSU is actually one of the companies that supplies Cisco with the optical components used in its products.
Currently, Nortel Networks (NYSE: NT), which sells optical equipment and components, is the largest player in the optical networking industry. According to the latest data, Nortel has the biggest market share of the optical networking vendors. Lucent Technologies (NYSE: LU) ranks second. Cisco, a late entrant to the field, showed the fastest growth last quarter. It shouldn't be surprising that, in my reports for Motley Fool Research on Cisco, I've identified optical as one of the biggest threats to Cisco's future success.
In the rest of today's report I'll focus on the fundamental difference in how Nortel, Cisco, and Lucent have approached their optical businesses, some of the advantages and disadvantages of their strategies, and where JDSU fits into this part of the equation.
When you buy a computer from a company such as Dell Computer (Nasdaq: DELL), it includes components such as a microprocessor, memory chips, and the hard drive. Dell makes none of these components. Its production is essentially outsourced to suppliers such as Intel (Nasdaq: INTC), Micron Technology (NYSE: MU), and Seagate Technology (NYSE: SEG).
Cisco's approach to its optical components manufacturing is similar in many ways. In fact, when asked why Cisco has steered clear of acquiring its own optical components manufacturer in a recent interview, Carl Russo, Cisco's group vice president of optical networking, said:
"If we were living in a world of rough stasis, where technology wasn't changing very much, you could say that there's not very much risk to owning component manufacturing facilities. But, the truth is that optical components are being obsoleted every half minute. Why would you want to buy a component vendor just so you could guarantee yourself a source of supply of a component that's obsolete three weeks later? By staying out of that business, we have created the most appealing of customers for all of the components companies. We help them; they help us. The last thing I want to do is own a component source."
This doesn't mean, however, that Cisco is devoid of any optical component plants or manufacturing capabilities. It recently unveiled a new optical plant. Cisco's strategy is different from that of its competitors. According to Carl Redfield, head of manufacturing for Cisco, "We develop the processes and then help other companies to develop the kinds of competencies so they can produce our products the way we want them produced."
Cisco's strategy of setting up and refining manufacturing processes on its own, and then passing these processes on to its contract manufacturers, enables it to cut costs, increase efficiency, and better meet demand. In addition, it allows Cisco to have lower levels of fixed assets and inventory on its books, which can lead to improvement in turnover ratios and better returns on invested capital. From a Rule Maker perspective, this strategy keeps the Foolish Flow Ratio down. It also reduces the amount of capital necessary to run the business, which should result in a higher Cash King margin.
So far, Nortel -- and, to a lesser extent, Lucent -- have manufactured the majority of their fiber optic components in-house. But, as discussed more fully in this month's Internet Report, both Lucent and Nortel are either planning to spin off their optical components businesses or are thinking about it. (The focus companies in the Internet report are Avanex (Nasdaq: AVNX), Corning (NYSE: GLW), JDSU, Nortel, and Lucent.)
By spinning off these businesses, Nortel and Lucent may also be providing benefits to their shareholders that reach beyond the improved financial statements mentioned above. A large percentage of the optical components made by Nortel are used in-house. On the other hand, two-thirds to three-fourths of the optical components produced by Lucent are sold to external customers. It is likely that potential customers of both of these businesses are hesitant to buy from Nortel and Lucent because they don't want to enrich their competitors.
If these businesses are spun off into separate entities, they should increase their customer base. Presently, the optical components businesses of both companies do not have a lot of excess capacity. However, when you take into account forecasts that the optical components market could grow at an annualized rate of 15% to 20% over the next 25 years, it should be easy to understand why the possibilities of success are greater for these companies as independent entities.
This spin-off activity could have a negative effect on JDS Uniphase. However, its product portfolio is more extensive than that of any of its competitors, and it already has relationships with the established players in this industry, as well as the emerging start-ups. As long as it continues to execute, it should continue to fare well. It should also be noted that Lucent and Nortel are JDSU's largest customers.
More Nokia and Yahoo! in the house
With proceeds from the sale of Gap, Inc. (NYSE: GPS) and October's $500 monthly investment, the Rule Maker has purchased 34 shares of Nokia (NYSE: NOK) at a price of $31.31 and 17 shares of Yahoo! (Nasdaq: YHOO) at a price of $60.63. Both companies have exciting expanding possibilities, strong cash flow, good name brands, and solid fundamentals. Rule Maker manager Matt Richey made a case for Yahoo! in "A Vote for Yahoo!" on October 9, and Richard McCaffery made a case for Nokia in "Nokia's Price Is Right" on October 10.
Phil Weiss, TMF Grape on the discussion boards
