Tech Outlook: Light Shines Ever Brighter on Optical Networkers

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The investment rule in networking this year is: The closer to the source of light, the higher the valuation and the higher the stakes. And there's no sign that trend is changing.

Investing in companies that build bandwidth, or network capacity, has been a major market theme ever since the Nasdaq Composite Index took off on its hair-raising ride last October. As telecom companies build networks to accommodate the ever-rising tide of phone and Internet traffic, demand grows for gear that makes communications lines faster and more efficient. Demand, in fact, has been so strong that the losers in the network-equipment game have been those, like Lucent (LU), that couldn't keep up with it.

Investors have noticed that there's not enough of this gear to go around, so they've pushed valuations sky-high. With stocks getting healthier and healthier, and technology changing practically by the day, blockbuster consolidations have become commonplace and start-ups are finding it easy to earn $30 billion valuations when they come public. So for now, the question is how quickly the next wave of consolidation will arrive.

Big Numbers

Take the widely discussed, now-scuttled talks between optical players Corning (GLW) and Nortel (NT), which if completed would have been the largest tech merger ever. The deal was all about lasers and laser parts -- the origin of light in the network, if you will. Likewise, JDS Uniphase (JDSU) put together a $40 billion deal with rival laser maker SDL (SDLI), just days after closing a $15 billion merger with E-Tek.

The Few, the Proud Some optical networking equipment plays.
Company	Recent price	Market cap (billions)
JDS Uniphase (JDSU:Nasdaq)	119 7/8	$93.75
Corning (GLW:NYSE)	286 1/2	79.62
SDL (SDLI:Nasdaq)	361 3/4	31.3
Corvis (CORV:Nasdaq)	95 11/16	31.86
ONI (ONIS:Nasdaq)	105 1/8	13
Source: First Call/Thomson Financial.

These deals were founded on the economics of scarcity and the thinking that mergers make it easier to pump out the parts people want. But after all of the recent mergers, there's another kind of scarcity at work: a scarcity of companies. For instance, when Lucent carves out its semiconductor and optical component unit this year, it will become just the fourth major player in the optical market, joining Corning, JDS Uniphase and SDL. (That number will be three, of course, when JDS completes its SDL buy.) In a market this size with this kind of demand, that is a fairly small headcount.

The companies argue the linkups are necessary to provide a broader range of products and manufacturing capabilities. Others would argue it's a winner-take-all race for market share and ultimately price control and profit margin.

Inevitably, companies are bucking that trend. Even with the Corning linkup dead for now, it's possible Nortel will find a way to separate its parts business, creating another big player. And don't forget Alcatel Alsthom (ALA), which is moving to separate its opticals operation. And just as inevitably, some in that new crowd will be washed away down as the waves of consolidation lap the next optical shores.

Risk and Rewards

Chasing the bandwidth buildout has been hugely lucrative, rewarding investors richly. These soaring stock valuations have helped companies acquire others. And investors have shown they are more than willing to continue in this direction as witnessed by the IPOs of Corvis (CORV) and ONI Systems (ONIS), to name two. But you have to wonder what will happen when investors stop pouring the money in, and new networks can't get funded, and new equipment can't be purchased and demand for optical parts dries up.

For now, though, those sentiments seem silly, when there is so much more Internet to build.