The genesis of the telecom optical components industry, as we know it today, was seeded in the research labs of major equipment telecommunications vendors of the 1980’s, companies such as Nortel, Lucent and Alcatel. The optical components that were developed were the key to winning the race in DWDM and OC-192. Those that had the components technology or the scale to drive the supply chain, dominated the burgeoning optical transport market of the late nineties into early 2000. These companies drove component business groups to serve the internal market and feed into the system - level product lines – thereby ensuring market differentiation. Some companies drove these component groups as cost centers and the profit margin went to the system business.

When capex budgets started to dry-up by the middle of 2001 and the frenzied deployment of 10Gb/s DWDM long-haul systems reduced to a trickle, the obvious and immediate fix to improve finances were to reduce fixed costs associated with component design centers and optical chip wafer Fabs. Deals were quickly made to divest and merge the captive component divisions with either existing merchant suppliers or with start-ups that were able to catch the IPO window. Since the burst of the telecom bubble, the industry has slowly clawed its way back to some level of  recovery even with the emergence of new component suppliers such as Optium, Opnext and Finisar. However, with remnants of VC-funded start-ups sputtering along, the emergence of low cost manufacturers from the Asia-Pacific region along with general oversupply in the industry, the return to profitability has slowed with some companies suffering occasional losses. Even the minimally profitable companies continually face the challenges of restructuring and off-shoring while addressing the need to further invest in leading edge optical products.

Not all is doom and gloom however. Bandwidth growth has allowed service providers to expand their infrastructure on real revenues coming from bandwidth demand. Spending levels in 2005-2008 were at a high in both terrestrial and submarine networks and component company valuations did recover modestly. Behind this trend the telecom optical components industry has improved palpably. At trade shows and executive forums, the topic at the top of the list is industry consolidation, which many agree is a long-term solution.  Several deals were made to this effect, but not at a pace or degree to produce lasting effect.

Then, in late 2008, strains in the financial industry brought a new round of difficulties that resulted in a freeze in spending patterns. Only now are we seeing infrastructure spending sustainably on the rise. In fact, we expect to see a continued recovery with CAGR back at 2005-2008 rates before long.

Going forward we think the fundamental problem that plagued the optical industry will have been addressed. In our view there are three key developments underway that will move the industry forward at better rates, starting now and lasting into 2010.

1) Service providers and system vendors recognize that the health of component suppliers is necessary to ensure stable and reliable supply with continued innovation coming from the bottom of the supply chain.

2) Component companies are right-sizing their businesses to run at >30% gross margin either by fully utilizing Fabs and/or outsourcing and streamlining operations.

3) Much like in 2000, M&A and consolidation will come out of necessity more so than luxury. But a second shakeout may be in the cards as operating winners and losers become more apparent. This will lead to a much healthier future.

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