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Does Success of Baidu, Facebook and Google Mean Better Days Ahead for the Global Optical Communications Industry?

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As Facebook valuation reached $100 billion and many Internet content providers reported steadily increasing profits, the majority of vendors in the global communications industry continue to search for a sustainable economic model. Network operators have not yet found a solution for improving returns on the increasingly expensive investments into networking infrastructure required to support Internet traffic growth. Average profitability of communication equipment manufacturers and suppliers of components is volatile and likely to remain so until their customers find the right economic model to justify infrastructure investments. There are exceptions. Large companies like Cisco and Intel remain highly profitable, and many midsize suppliers of communication semiconductors substantially improved their profitability in 2010–2011. Is there hope for the rest of the supply chain?

Traditional economic theory relates success of service providers to their scale of operations or number of customers. In this context, service providers offer the infrastructure connecting content providers, who want access to the largest number of customers, and end-users, who want access to the widest selection of services. A proven strategy for success is to find a pricing balance between the two sides of the market and maximize revenues. 

Striking that balance is easier said than done. Companies like Facebook pay very little (if anything) for the networking infrastructure made available to them. If access to the infrastructure is free, a successful business does not need to own the network. A company can just scale the number of customers using an online platform and take advantage of the scale by selling advertisements, for example. With more than 800 million users, Facebook has double the users of AT&T, NTT, and China Telecom combined. Also, none of the service providers have control over its customers’ online activities, so these providers really just make networking infrastructure available for others.

Judging from market capitalization of the companies mentioned above, the financial markets accept this economic model, but it has yet to be proven by time. Long-term success of companies like Facebook hinges on the loyalty of their customers. The changing fortune of MySpace, Facebook’s predecessor, is an example of customers adopting a platform for a few years and moving on. It is possible that highly successful content providers of today are just testing new business models for more established companies to move into this market.

There is very little doubt that 20–50 years from now, the global optical networking infrastructure will be as ubiquitous as the electric grid is today. By that time, network operators will be large and stable but not very profitable utility businesses. The question is whether network operators have an opportunity to capitalize on their investments in networking infrastructure before it turns into a utility. Network operators are well aware of this prospect and have been actively looking for value added services to grow their revenues. For example, Verizon acquired two cloud computing vendors in 2011 and it just announced Viewdini - a mobile video portal streamlining access to videos from a wide range of content providers, including cable operators, websites and other popular video sources.

Wireless service providers seem to have found the right model to increase revenues and fund infrastructure upgrades by offering tiered services, so customers pay extra for more usage and higher speeds. Wireless broadband revenues are on the rise, and demand for ever more bandwidth is not diminishing. Tiered services are just starting to be implemented in wireline broadband access, and these will become widely used, as new applications emerge and bandwidth consumption increases. Higher-speed LTE, Wi-Fi, and FTTx networks will flood wireline access networks and eventually the rest of the global networking infrastructure. The only question is whether this will happen two to three years or decades from now and what segments of the supply chain will prove the most profitable.

For the past decade, service providers invested as little as possible into networking infrastructure to stay profitable and keep the networks running. They continue to do so in 2012, and financial crises in Europe forced many of them to further curb investments. However, highly profitable content providers are starting to invest more into their own networking infrastructure, mostly to support mega-datacenters running their applications. This certainly creates an additional stream of revenue for network operators that lease fiber and/or provide networking services to companies like Facebook. A good illustration of this trend is TeliaSonera’s recent announcement of its contract for providing Facebook’s managed network services in Europe.

Growing service revenues seems to be top the agendas of many equipment manufacturers as well. Ericsson has been emphasizing this for years and continues to do so, after reclaiming its number-one position among communication equipment vendors in 2011. Ericsson is focused on solving customer problems and having the latest technology is a necessary element of this strategy, rather than a goal on its own. Cisco is another champion of delivering complete customer solutions rather than just the latest technology, and the company has proudly transformed itself again in 2011, divesting technologies it no longer needs and acquiring new ones.

Huawei and ZTE continue to gain shares in the telecom market and remain profitable. Minor declines in profitability of these vendors reported for 2011 are related to aggressive investment into opening new R&D and customer support centers around the world and hiring more people to expand ongoing operations. In contrast, Alcatel-Lucent, Ciena, Nokia Siemens Networks, and Tellabs continued to reduce staff in 2011, trying to improve profitability or at least curb losses. Many smaller telecom equipment manufacturers are still struggling to reach profitability.

Financial performance of communication semiconductor vendors, led by Broadcom, Intel, and Texas Instruments, improved substantially in 2010–2011. Altera and Linear Technologies reported net profit margins of 37%, and a majority of semiconductor vendors reported margins of around 20%—well above average for the communications industry. Increasing data rates and growing complexity of next-generation signal processing and wireless chips account for most of this improvement, but growth in sales of integrate circuit (IC) chips for FTTx and 40Gbps applications also helped companies like Maxim IC and Semtech. Apart from Applied Micro, Mindspeed and Vitesse, all other vendors in this segment reported a profit in 2011.

Suppliers of optical components and modules continue to struggle however. The average net margin for this vendor category did improve in 2010, but it reached only 3%, while revenues spiked by about 30% that year. Growth in this market segment slowed in 2011, and the average net margin dropped to –1% for the year. Emcore, Oclaro, and Opnext are among the worst performers with negative net margins as low as –15% and even –25%. While these low margins can be blamed partially on flooding at Fabrinet in the end of 2011, most of these suppliers’ issues are related to profitability of ongoing operations rather than any disruptions. It is not surprising that Emcore had to sell a significant portion of the business to Sumitomo, while Oclaro and Opnext agreed to merge in early 2012.

The net profit margin of Finisar, the number-one supplier in the optical component and module segment, improved to 10% in 2010, when it was helped by rapidly increasing sales of high-data-rate products, including 8Gbps, 10Gbps, and 40Gbps modules. However, the company’s net margin dropped to 4% in 2011 as growth in revenues slowed down. Ironically, the smallest of the publicly traded vendors in this segment report decent profitability. Net margins of O-Net and Oplink were 25% and 19%, respectively, in 2011. Staying away from highly competitive parts of the market and limiting R&D spending might have been two of the reasons for success of these vendors in 2011, but is this approach sustainable? Development of 40Gbps and 100Gbps products is very expensive and remains a burden for leading vendors, who cannot afford to miss this opportunity and hope that the investment will pay off one day.

There are several good reasons to be optimistic, as discussed in The State of the Optical Communications Industry report (www.LightCounting.com/reports.cfm) released by LightCounting this week. These reasons include

  • Deployments of FTTx access around the world make huge amount of bandwidth available to end users, who are just starting to utilize it as high-definition video streaming services become more popular. Bottlenecks in metro-access networks, most of which have not been yet upgraded to support FTTx users, are very likely to give a boost to the industry supply chain.
  • Major upgrades to data centers worldwide are clearly underway, fueled by online applications and services. New data centers require much more optical connectivity than in those of the past because of increased data rates and changes in data center architecture.

Consolidation is slowly but steadily improving industry health. Economy of scale is critical for service providers and the whole supply chain. Consolidating service providers results in a smaller number of much larger companies, impacting the entire supply chain. These large service companies find dealing with a small number of large vendors of equipment easiest, and large vendors, in turn, prefer to deal with just a few large suppliers of components and modules.

Highlights of the latest M&A activity include

  • The $1.7-billion acquisition of Cable & Wireless by Vodafone announced in April 2012 suggests that the blocked merger of AT&T and T-Mobile has not stopped consolidation among service providers.
  • Verizon’s acquisitions of cloud computing vendors Terremark and Cloudswitch in 2011 are sure signs that service providers are actively looking for new streams of revenue.
  • Ericsson’s $1.1-billion acquisition of Telcordia and Nokia Siemens’s $975 million acquisition of Motorola’s Wireless Networks confirm global ambitions of European equipment manufacturers.
  • The merger of Oclaro and Opnext announced in April 2012 created the second-largest well-diversified supplier of optical components and modules.

Competition across the supply chain is changing the market landscape, including the following:

  • The rise of Huawei and ZTE forced competition to reduce cost and transfer a lot of production and even some R&D activities to China. Both Huawei and ZTE continued to expand their operations and gained market share in 2011.
  • Cisco’s dominance in the switch and router market is being challenged by Juniper on high-end products and HP on the low end, forcing the industry leader to restructure.
  • Chinese suppliers of optical components continue to gain market share. While all Western suppliers of components and modules had a slow year in 2011, Chinese suppliers increased sales by 20–30% on average, thanks mostly to the booming FTTx market.

The LightCounting team will be at OptiNet China (http://www.optinetchina.com), located at the Presidential Plaza Hotel in Beijing, May 30–31, 2012. To set up a briefing with one of our analysts at this industry event, please contact Renee Isley (Renee@LightCounting.com ).

About LightCounting
LightCounting, LLC is a leading optical communications market research company, offering semiannual market update, forecast, and state of the industry reports based on analysis of publicly available information and confidential data provided by more 20 leading module and component vendors. LightCounting is the optical communications market’s source for accurate, detailed, and relevant information necessary for doing business in today’s highly competitive market environment. Privately held, LightCounting is headquartered in Eugene, Oregon. For more information, go to www.LightCounting.com, or follow us on Twitter at www.twitter.com/lightcounting.