Optical industry restructuring: The analysts' view
The view that the optical industry is due a shake-up has been aired periodically over the last decade. Yet the industry's structure has remained intact. Now, with the depressed state of the telecom industry, the spectre of impending restructuring is again being raised.
In Part 2, Gazettabyte asked several market research analysts - Heavy Reading's Sterling Perrin, Ovum's Daryl Inniss and Dell'Oro's Jimmy Yu - for their views.
Part II: The analysts' view
"It is just a very slow, grinding process of adjustment; I am not sure that the next five years will be any different to what we've seen"
Sterling Perrin, Heavy Reading
Larry Schwerin, CEO of ROADM subsystem player Capella Intelligent Subsystems, believes optical industry restructuring is inevitable. Optical networking analysts largely agree with Schwerin's analysis. Where they differ is that the analysts say change is already evident and that restructuring will be gradual.
"The industry has not been in good shape for many years," says Sterling Perrin, senior analyst at Heavy Reading. "The operators are the ones with the power [in the supply chain] and they seem to be doing decently but it is not a good situation for the systems players and especially for the component vendors."
Daryl Inniss, practice leader for components at Ovum, highlights the changes taking place at the optical component layer. "There is no one dominate [optical component] supplier driving the industry that you would say: This is undeniably the industry leader," says Inniss.
A typical rule of thumb for an industry in that you need the top three [firms] to own between two thirds and 80 percent of the market, says Inniss: "These are real market leaders that drive the industry; everyone else is a specialist with a niche focus."
But the absence of such dominant players should not be equated with a lack of change or that component companies don't recognise the need to adapt.
"Finisar looks more like an industry leader than we have had before, and its behaviour is that of market leader," says Inniss. Finisar is building an integrated company to become a one-stop-shop supplier, he says, as is the newly merged Oclaro-Opnext which is taking similar steps to be a vertically integrated company. Finisar acquired Israeli optical amplifier specialist RED-C Optical Networks in July 2012.
Capella's Schwerin also wonders about the long term prospects of some of the smaller system vendors. Chinese vendors Huawei and ZTE now account for 30 percent 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 percent or less [optical networking] market share, that really is not a sustainable business given the [companies'] overhead expenses," says Schwerin.
However Jimmy Yu, vice president of optical transport research at Dell’Oro Group, believes there is a role for generalist and specialist systems suppliers, and that market share is not the only indicator of a company's economic health. “You have a few vendors that are healthy and have a good share of the market,” he says. “That said, when I look at some of these [smaller] vendors, I say they are better off.”
Yu cites the likes of ADVA Optical Networking and Transmode, both small players with less than 3 percent market share but they are some of the most profitable system companies with gross margins typically above 40 percent. “Do I think they are going to be around? Yes. They are both healthy and investing as needed.”
Innovation
Equipment makers are also acquiring specialist component players. Cisco Systems acquired coherent receiver specialist CoreOptics in 2010 and more recently silicon photonics player, Lightwire. Meanwhile Huawei acquired photonic integration specialist, CIP Technologies in January 2012. "This is to acquire strategic technologies, not for revenues but to differentiate and reduce the cost of their products," says Perrin.
"There is a problem with the rate of innovation coming from the component vendors," adds Inniss. This is not a failing of the component vendors as innovation has to come from the system vendors: a device will only be embraced by equipment vendors if it is needed and available in time.
Inniss also highlights the changing nature of the market where optical networking and the carriers are just one part. This includes enterprises, cloud computing and the growing importance of content service providers such as Google, Facebook and Amazon who buy components and gear. "It is a much bigger picture than just looking at optical networking," says Inniss.
"There is no one dominate [optical component] supplier driving the industry that you would say: This is undeniably the industry leader"
Daryl Inniss, Ovum
Huawei is one system vendor targeting these broader markets, from components to switches, from consumer to the data centre core. Huawei has transformed itself from a follower to a leader in certain areas, while fellow Chinese vendor ZTE is also getting stronger and gaining market share.
Moreover, a consequence of these leading system vendors is that it will fuel the emergence of Chinese optical component players. At present the Chinese optical component players are followers but Inniss expects this to change over the next 3-5 years, as it has at the system level.
Perrin also notes Huawei's huge emphasis on the enterprise and IT markets but highlights several challenges.
The content service providers may be a market but it is not as big an opportunity as traditional telecom. "It is also tricky for the systems providers to navigate as you really can't build all your product line to fit Google's specs and still expect to sell to a BT or an AT&T," says Perrin. That said, systems companies have to go after every opportunity they can because telecom has slowed globally so significantly, he says.
Inniss expects the big optical component players to start to distance themselves, although this does not mean their figures will improve significantly.
"This market is what it is - they [component players] will continue to have 35 percent gross margins and that is the ceiling," says Inniss. But if players want to improve their margins, they will have to invest and grow their presence in markets outside of telecom.
"I like the idea of a Cisco or a Huawei acquiring technology to use internally as a way to differentiate and innovate, and we are going to see more of that," says Perrin.
Thus the supply chain is changing, say the analysts, albeit in a gradual way; not the radical change that Capella's Schwerin suggests is coming.
"It is just a very slow, grinding process of adjustment; I am not sure that the next five years will be any different to what we've seen," says Perrin. "I just don't see why there is some catalyst that suggests it is going to be different to the past two years."
This is based on an article that appears in the Optical Connections magazine for ECOC 2012
Has the restructuring of the optical industry already started?
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.