Sector Spotlight: Optical-Component Outfits Get Ready to Pair Off

Making optical components is almost rocket science. But why should it be so hard to figure which way the rocket is headed?

While up has been the winning guess so far, no one can say for sure how long that will hold.

What seems certain for the moment is that there is a phenomenal demand for a painfully short supply of fiber-optic widgets like amplifiers, lasers and communications chips. That fact continues to shoot JDS Uniphase (JDSU), Corning (GLW) and SDL (SDLI) well into high orbit.

Happy Days? 2000 movement at Corning, JDS, SDL

But supply won't be limited forever: Each of the big firms is pushing ahead with massive expansion plans, and the field will get much more crowded when the component-business spinoffs pending from Nortel (NT) and Lucent (LU) take effect.

Enter consolidation.

Looking down the road, expect the Nortel and Lucent component arms to further raise the competitive stakes by using their shares to tempt leading start-ups. Picture, hypothetically, a Lucent-Avanex (AVNX) tie-up or a Nortel-Bookham (BKHM) colossus.

"I don't want to say it's only a matter of time before these companies get acquired, but it is certainly heading in that direction," says Ken Smith with Munder funds.

"The more stock [Nortel and Lucent] bring into this game, the more they will beat JDS in acquisitions," says RHK's Jay Liebowitz, senior analyst for optical components. "And these bidding wars will get expensive."

Meanwhile, demand, which probably will remain strong for years to come, is nonetheless threatened by a shrinking cash supply. The shiny new all-optical networks of the industry's new Internet dreams may not get funded. As TheStreet.com has recently explored, questions loom over the health of the industry. This has sent a chill through much of the networking sector, as phone and Internet service companies predict a leveling off of continued buying power.

Lead Foot

Yet judging by the current round of quarterly earnings reports, there's plenty of fuel in the tank for now.

SDL blew past earnings expectations Thursday despite Lucent's negative impact. SDL told analysts that it expects to hit $1 billion in revenue next year, doubling this year's breakneck growth rate. Corning has preannounced it will beat forecasts for the third quarter, its fourth positive surprise in a year. And if SDL could sidestep the Lucent pothole, there's no reason fellow Lucent supplier JDS can't also.

In probably the most glaring example of just how hard it is to predict the growth of this wildly fast-moving component industry, market researcher RHK recently adjusted its forecast for the year. The adjustment wasn't minor: The top industry source had underestimated growth by $2.24 billion. The previous forecast was $2.77 billion. The new guess: $5 billion, an 80% increase.

Network service providers, in order to survive the ramping volumes of Internet traffic, have had little choice but to turn quickly to the greater capacities offered through fiber optics. This has created a gold rush in network equipment, the most precious vein being the lasers and amplifiers and various chips that help create and help speed lightwaves of information across the Net.

Investors still love that story line.

"Everyone has underestimated demand," says Munder's Smith. "One of the things we get excited about is what is only beginning to happen in access," Smith adds, referring to the long-awaited opening of the bottleneck on the users' end of the network. "I don't think we have yet seen the tidal wave of traffic we are going to get when broadband and higher capacities become available."

But that's the thing about rockets: It takes a lot of fuel to counter the effects of gravity. With valuations this high -- JDS' market capitalization is $10 billion more than Ford (F) and General Motors (GM) combined -- even the slightest crimp in the fuel line could set off a frightful plunge.

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