Are Fund Managers Still in Love With Optics?

Fans of Nortel, JDS and others are watching the numbers more closely.
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If you own one of the 949 mutual funds with a stake in

Nortel

(NT)

, you may be wondering how your money manager has weathered the unnerving period since the company's surprise

revenue disappointment. Well, those that weren't selling were gripping the arms of their chairs with their eyes squeezed shut, chanting:

looonng-terrrrrrrm

;

loooonng-terrrrrrm

.

The latest troubling news: A Bank of America analyst reportedly voiced concerns about inventory problems and said the weakened stock could drop from the mid-30s currently to the 20s.

It's not that money managers are all that surprised by the recent shakeout in the precariously high-priced optical sector. "We've been anticipating a valuation correction for quite some time," says Bruce Bartlett, a portfolio manager at

(OPPSX)

Oppenheimer Growth. But Bartlett, like probably many others, didn't think it would look this brutish. Some of the biggest names in the sector, like Nortel and

JDS Uniphase

(JDSU)

, have dropped 40% to 50% from their highs earlier in the year. "We thought it would be a three- to nine-month process," he explains.

So, now that the optical sector has been the latest "hot" sector to get knocked down by the bear's claw, what do the pros think of the group? The answer: Optics still has its die-hard fans, but the recent selloff and rising concerns -- a slowing macro-economy, pullbacks in spending by telecom service providers and inventory backups at networking equipment companies like

Cisco

(CSCO) - Get Report

-- have money managers taking a harder look at the numbers.

"Sentiment on the Street has certainly changed. People are looking at the top line a lot more than they had been," says Mike Hahn, associate portfolio manager for

Merrill Lynch's

(MAFOX) - Get Report

Focus 20, which has a hefty 15% stake in optics. Adds Hahn, "Tech is one of the more cyclical sectors, and a lot of people tend to forget that."

This year has seen a gradual toppling of other tech strongholds, from plays on Web-based business-to-business to wireless stocks, until optics appeared to be the only holdout. There's been no shortage of vocal cheerleaders for the group. Bandwidth groupies like George Gilder, an early fan of JDS Uniphase, have touted the promise of souped-up pipes to carry massive streams of data. In his

new book, Gilder quotes

Mae West

in describing the allure of mega-bandwidth: "Too much of a good thing can be wonderful."

Market research firm

RHK

predicts North American revenues for optical-equipment makers will grow by about 38% next year -- a slowdown from this year's 60%, but still a pretty snappy clip.

Given the growing concerns, does a growth manager really need to have a stake in optics? Yes, says Catherine Dudley, manager of

(SCFAX) - Get Report

State Street Research MidCap, which has about 5% in the sector. (The weighting was more like 9% before the downturn in optics stocks.) Despite a couple of big disappointments, companies like

Juniper Networks

(JNPR) - Get Report

,

SDL

(SDLI)

and

Corning

(GLW) - Get Report

keep pumping out good numbers, she says.

But there aren't many companies in the mid-cap range that offer quality revenue and earnings growth, she adds. Last summer Dudley sold

Ciena

(CIEN) - Get Report

after it had quintupled in price and the

market cap grew too big for her mandate.

For now she's holding off on new buys, because she considers the overall economic outlook to be more important than the potential of individual companies. "I think in order to add to the really aggressive, hypergrowth stocks, you need to have an upwardly trending market environment, which we absolutely have not had for the last six months. The macro environment has been deteriorating. The potential for demand for tech has been slowing down."

At

(TEQUX)

Transamerica Premier Equity, Jeff Van Harte has no holdings in optics, though he's enthusiastic about the fundamentals of the sector. He thinks the stocks are still too expensive, and he's unnerved by "lumpy" product cycles. "These are very expensive pieces of technology," he says. "It's not like they're selling millions of PCs. A network may order up a lot of switches, then just stop for a while."

Some investors fear that optical-components makers may be primed to go through the same boom-bust inventory cycle as semiconductors, says Merrill Lynch's Hahn. "That's really why Nortel's announcement scared everybody so much."

Another factor: the uncertain prospects of some of the service providers who buy from networking-equipment companies. "Everybody's in a build-it-and-they-will-come mode," says Van Harte. "I believe that, but not all of the people that build it will make a return on capital." He thinks consolidation among service providers would force reductions in capital spending, which would hurt the stocks of equipment makers.

Already, carriers such as

WorldCom

(WCOM)

,

AT&T

(T) - Get Report

and

Williams

(WCG) - Get Report

have said they'll

spend less next year on networking equipment. Some money managers question whether restructurings at AT&T and WorldCom could further disrupt spending. On Thursday, BellSouth said it plans to curtail equipment spending.

And in a development troubling to investors, equipment makers like Nortel,

Lucent

(LU)

and Cisco, aiming to boost revenues, have started

loaning money to the same network builders that buy their products.

Those who own optics stocks take solace in the long-term outlook because the pressure remains on carriers to upgrade their networks, both to cut costs and to keep customers. And they say that, while overall spending may slow somewhat, the percentage spent on optics is increasing. Hahn says he'll feel comfortable as long as telecom-service spending increases in the range of 15% to 20% for next year, though smaller spending hikes might make him nervous.

Money managers are also concerned about signs of backups in inventory. Most recently, Cisco said

its inventory of communication chips had grown 59%. Nortel and Lucent also reported

increases in inventory for the third quarter. "Some component makers might be more exposed than others," says Paul Rokosz, a manager at

(INVPX)

AXP Equity Select. "We're trimming or at the margin on a couple of the components vendors that might take longer to recover."

But Rokosz, like several other money managers interviewed, is adding to other positions, gauging that optics is "still a very good long-term opportunity." He says the market has been too quick to punish optics stocks indiscriminately, without heed to the quality of individual companies.

Both he and State Street's Dudley like the prospects for networking growth in up-and-coming metro markets, as opposed to plays on the networking backbone. In that area, Rokosz likes

ONI Systems

(ONIS)

, while Dudley owns

Redback Networks

(RBAK)

.

At Focus 20, Hahn says managers are seeking out companies, like SDL, that fill unique market niches. "We're trying to stay away from companies that make things like transceivers. Everybody makes those.

But no one's been able to make a pump laser with power and yield like SDL," he says. SDL recently agreed to be acquired by JDS Uniphase.

Another manager favorite is

Avanex

(AVNX)

, owned by both Focus 20 and AXP Equity Select. Avanex has a product that helps carriers push more colors of light through an optical fiber, allowing them to do more with existing cables.

At Oppenheimer Growth -- which claimed the biggest stake in six leading optical stocks, as of its most recent disclosure in May -- Bartlett says he's investing in multiple levels of the food chain, from optical networkers to component companies like JDS Uniphase. He goes one tier further down, singling out companies that serve the components suppliers as a hot area for growth. A favorite is

Newport Corp.

(NEWP)

, which draws over 50% of its business from manufacturing automation equipment and optical-test equipment.

At least one value manager has jumped into the game. At

(TVAFX) - Get Report

Thornburg Value -- a fund that's admittedly not hard-core about cheap prices -- portfolio manager William Fries says he's been picking up some networking-equipment makers. (Because he's still buying, he declines to name them.) "The stocks are still pretty richly valued, in the traditional sense, but we think they'll grow into the valuation," he says. "Value is more than just

P/E. This whole area is going to have exceptional growth over the next four or five years." But his fund's exposure to optics remains "modest," he says.

For all the cherry-picking going on, keep in mind nobody's calling a bottom yet. "Can

networking stocks go down 10% or 20%? Yeah, but I think at this point the upside is a lot greater than the downside," says Hahn. The outlook is good enough for Focus 20 to have started picking up shares of one of the "younger" optical-components makers, he says.

But Bartlett says we may have seen the top, at least from a valuation perspective. "I don't think that we will return to the peak valuation levels in this group that we saw in 2000. I think the multiples have been permanently ratcheted down."

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