The view that consolidation in the optical networking industry is needed is not new. For a decade, ever since the end of the optical boom in 2001, consolidation has been called for and has been expected. And while the many optical startups funded then have long exited or been acquired, the optical industry continues to support numerous optical networking and component generalist and specialists.
Given the state of the telecom market, is a more fundamental industry restructuring finally on its way?
"The business model of the communication sector needs to change, and change in a relatively short order"
Larry Schwerin, CEO of Capella Intelligent Subsystems
Larry Schwerin, CEO of Capella Intelligent Subsystems, believes change is inevitable. He argues that the industry supply chain will change, especially as firms become more vertically integrated.
"This is not to say that the market and demand are not there," says Schwerin, but the industry is stuck with a decade-old structure yet the market has changed.
Optical market dynamics
Schwerin starts his argument by highlighting certain fundamental drivers. IP traffic continues to grow at over 30% a year, while the nature of the traffic is changing, especially with cloud computing and as users generate more digital media content.
“The current rate of bandwidth growth coupled with the rate of CapEx spend, the gap is widening and the revenue-per-bit is dropping,” he says. “Some argue that bandwidth growth will slow down as operators charge [users] more, but to date this hasn't been seen.”
These trends are welcome for the optical companies, says Schwerin, as operators adopt lower layer, optical switching as a cheaper alternative to IP routing. “The number of [wavelength-selective] switches per node is growing quite dramatically," he says. "We are now seeing deployments with, on average, 6-8 switches per node and people are projecting as many as 20 as people start deploying colourless, directionless, contentionless-based switching."
But such demand is coupled with fierce competition among numerous players at each layer of the optical industry's supply chain.
"Some 80% of the optics used by system vendors are bought. How do you differentiate on features above and beyond what you are buying?"
Supply chain
The annual global operator market for wireless and wireline equipment is valued at US $250bn, says Schwerin, using market research and financial analyst firms' data.
The global optical networking equipment market is $15bn. The Chinese vendors Huawei and ZTE now account for 30% of the market, while Alcatel-Lucent is the only other major vendor with double-digit share. The rest of the market is split among numerous optical vendors. "If you think about that, if you have 5% or less [optical networking] market share, that really is not a sustainable business given the [companies'] overhead expenses," says Schwerin.
The global optical component market is valued at $5bn. It is likely larger, anything up to $8bn, argues Schwerin, because of the Chinese optical companies supplying Huawei and ZTE.
"You have a $5-8bn market selling products into $15bn, and then the $15bn is trying to repurpose that material and resell it to the carriers - is that really what is going on?" says Schwerin. To this vendor hierarchy is added contract manufacturers, with different players serving the component and the system vendors.
The slim profits operators are making on their services is forcing them to place significant pricing pressure on the system companies that already face fierce competition. Meanwhile, the optical component and contract manufacturers are also trying to make money in this environment.
Looking at gross margin data from Morgan Stanley, Schwerin says that the system vendors' figures range from 35% for the low end to 40% at the high end. "What the figures highlight is a lack of differentiation," he says. "And, in part, it is because they are buying all the same technology."
Schwerin says that some 80% of the optics used by system vendors are bought. "How do you differentiate on features above and beyond what you are buying?"
The optical components vendors' gross margins of a year ago were 30%. More recent data shows these figures are down, with the only segment showing a rise being optical sub-systems.
What next?
Schwerin says one way to improve the health of the industry is greater vertical integration. How this will be done - which players get consumed and how - will only become clear in the next 2-3 years but he is confident it will happen. "There are just too many layers of the ecosystem and it is just too fragmented," he says.
Operator mergers and slower spending put pressure on vendors at each layer of the supply chain, inducing revenue stalls. "These swings seems to be more and more violent," says Schwerin. "It is difficult for companies to maintain themselves in these cycles, let alone innovate."
Schwerin highlights Cisco System's acquisition of silicon photonics start-up, Lightwire, earlier this year, as an example of a system vendor embracing vertical integration while also acquiring innovation. Another example is Huawei's acquisition of optical integration specialist, CIP Technologies.
"The business model of the communication sector needs to change, and change in a relatively short order," says Schwerin, who believes it has already started. He cites the merger between the two large optical component vendors, Oclaro and Opnext, and expects a similar deal among the system vendors: "One of those 5 percenters will be absorbed."
As the market further consolidates, and as system companies drive fundamental technologies, the components' market will start to shrink. "It is then like a chain reaction; it forces itself," he says.
Schwerin's take is that rather than continue with the existing optical component and contract manufacturing model, what is more likely is that what will be supplied will be basic optical components. Differentiation will be driven by the system vendors.