Venture Capitalists Turn Lemming Over Optical Networkers - TheStreet

Venture Capitalists Turn Lemming Over Optical Networkers

Even as the VCs pump money into the sector, there are signs that the rampant growth is slowing.
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The talk about lemmings following each other off a cliff is a myth, but the talk about venture capitalists exhibiting similar behavior has some merit.

Venture capital firms one after another are pumping money into optical-networking companies, all in an effort to grab the steep valuations investors have given to the sector's publicly traded companies. Those valuations have come thanks to healthy demand and projections of even more growth.

But as the VCs cut check after check, there are some signs the rampant growth is slowing. For instance,

Nortel Networks

(NT)

announced a third-quarter

revenue shortfall in optical sales Tuesday, which sent optical stocks into a dive Wednesday. A potentially bigger question is whether the companies still in development are now too far behind. If that's the case, investors may want to take an even closer look at these companies when they eventually hit the public markets.

The sector includes vendors like Nortel,

Lucent

(LU)

and

Ciena

(CIEN) - Get Report

, which sell optical equipment to telecom service providers such as

AT&T

(T) - Get Report

and

WorldCom

(WCOM)

. In turn, Nortel, Lucent, Ciena and others buy components for their equipment from the likes of

JDS Uniphase

(JDSU)

,

Corning

(GLW) - Get Report

and

SDL

(SDLI)

.

Big Growth

All of these companies are trying to keep up with annual 10-fold increases in traffic. The worldwide market for optical components is projected to grow to over $23 billion by 2003 from $6.6 billion in 1999, according to

RHK

, a telecommunications research firm.

"The need is very robust and will continue to be robust because the fundamental economics make sense," says Vinod Khosla, a partner at venture capital firm

Kleiner Perkins Caulfield & Byers

. Khosla has invested in several successful optical companies, including

Juniper Networks

(JNPR) - Get Report

,

Corvis

(CORV) - Get Report

,

Cerent

, which was acquired by

Cisco Systems

(CSCO) - Get Report

and

Siara Systems

, which was acquired by

Redback

(RBAK)

. Kleiner Perkins has also invested in start-up

Zaffire

.

Since early October, venture capital firms have funded at least 18 optical companies, according to

VentureWire

, a newsletter that tracks private companies and venture capital. Meanwhile, another four have lined up to go public, according to

Edgar Online

, which provides information on

Securities and Exchange Commission

filings. Some of the more promising private companies, according to two Internet infrastructure analysts, are

Astral Point Communications

, which makes optical multiservice provisioning devices;

Calient Networks

, which develops optical switches and software;

Chiaro Networks

, which develops optical routers; Zaffire, which develops systems for metropolitan networks; and

Tellium

, a developer of optical cross-connects that filed to go public on Sept. 22.

Losers

But for all the winners, there will be exponentially more losers, despite having ample cash from venture capitalists in hand.

The attraction remains strong, however, thanks to the steep valuations enjoyed by the publicly traded optical companies. Even after its announcement Tuesday, Nortel is trading at 45 times projected fiscal 2001 earnings, while JDS Uniphase is trading at almost 101 times projected 2001 earnings.

But few of the companies being funded stand a chance of winning similar valuations. "There are still opportunities today for optical-component companies to be billion-dollar companies, but probably only one out of every 10 that's venture-funded," says Gus Tai, a general partner at

Trinity Ventures

.

"There's been a lot of overfunding going on in the business, on both the systems and components side because there has been so much in the sector from a valuation standpoint," adds Fred Wang, a Trinity general partner who specializes in communications investments. "But there's a mismatch between the valuation of these investments and how big these opportunities are."

"The valuations for a second-round deal are higher than they might have been for a fourth-round deal two years ago," he continues. "Later-stage investors are giving these companies a lot of credit for things they haven't accomplished yet." Private companies raise funds by selling stock to venture capitalists and other private-equity investors in different "rounds," or stages of financing, before they go public. The value of the stock usually rises with each subsequent round.

As a result, says Khosla at Kleiner Perkins, "there's a much bigger difference between the winners and losers in a normal market. The bottom 80% of companies is valued on the basis of the top 20%. That's a problem. There are companies that don't deserve it. They're valued completely out of kilter and that shuts off the market for others."

Part of the problem stems from a

herd mentality that has manifested itself already in both the consumer and business e-commerce sectors. Then there's the issue of a growing number of inexperienced venture capitalists who possess the means to back companies but lack the technical expertise and experience to distinguish between the good and the bad. "There has been a huge inflow of not only dollars, but people, into the venture business," says Wang, who has invested in optical companies such as privately held

Kestrel Solutions

. Kestrel has made a big splash so far, raising $187 million though it has yet to get a product to market.

To make up for that lack of knowledge, those venture capitalists look for "the safer, more popular sectors to invest in that have already been legitimized by the seasoned venture capitalists," Tai adds. "Then the sector is saturated and the seasoned move on."