Projecting market growth through periods of uncertainty: do not give up on the optical networking industry
Global macroeconomic uncertainty dominated headlines in 2011 and it continues to do so in 2012. A slowdown in the economic growth of China and India, that clearly started in early 2012, is another confirmation of how interconnected the global economy is today. Looking at economies in Europe or the United States, China or India, not mentioning political situation in the Middle East—the problems seem to be everywhere, and most of them do not have easy and quick solutions.
Although many of these problems are not new, we certainly became much more aware of them, and the global networking infrastructure contributed to the improved awareness. Ignorance may not be bliss, but it is certainly taking us a while to learn how to live in this brave, new, well-informed world entangled in a set of complex issues that may take years, if not decades, to unravel. Companies, just like individuals, will have to learn to deal with uncertainty without being too distracted by issues that are out of their control. Focusing on tangible tasks, like making businesses more efficient or customers happier with products, is a much more constructive way of dealing with uncertain and uncontrollable future events.
Focusing on positive stories that are often hidden behind the negative ones (since bad news always sells better) can also help businesses navigate through a period of uncertainty. There was plenty of good news in 2011 for the communications industry. To start with, total revenues of the top twelve service providers increased by almost 10% in 2011, after two years of stagnation in 2009 and 2010. Mobile broadband services and cloud computing are driving this growth. While carriers are seeing improvement in their top lines, they are still being cautious about capital expenditures (CapEx) given the market uncertainty.
Over the long term, for a mature market, CapEx should grow in-line with revenue growth. In the short term, CapEx can rise and fall as individual technology programs are implemented and the policies of company managers change. As economic conditions improve, companies typically increase CapEx investments faster than revenue increases, to position themselves to capitalize on rising sales. If not for the macroeconomic uncertainty in 2011, CapEx of top twelve carriers should have been up by more than 10%, but the actual numbers suggest only a 3% increase in CapEx for the year. To be fair, the CapEx did increase by 3% in 2010, while sales were stagnating.
Despite a slowdown in the global economic activity in early 2012, majority of the leading service providers reported healthy revenue growth in the first quarter of the year. Their guidance for 2012 revenue and CapEx was moderately optimistic as well. LightCounting is projecting a modest 3% increase for the revenues of the top twelve service providers this year, but their CapEx is likely to decline by 2%. However, carriers are allocating a larger share of the CapEx budget to network infrastructure investments, resulting in a gradual increasing cash flow for the networking industry supply chain. This cash flow will continue to fluctuate on a quarterly time scale. Any delays in budget allocations within larger service providers, may lead to sharp drops in quarterly revenues for their suppliers, as illustrated by data reported by Alcatel-Lucent in Q1 2012, for example.
Sales of networking equipment were up by more than 10% in 2011 and suppliers of optical transceivers reported a 17% increase in 2011 sales, despite the disruptions caused by the earthquake in Japan and the flood in Thailand. Suppliers of telecom networking equipment had a very slow first quarter of 2012 and their guidance for the second quarter was mixed, suggesting that this market may be flat or may even decline this year. Even if the telecom equipment market remains slow in 2012, sales of optical components and modules are likely to increase by close to 10% in 2012, supported in part by investments in FTTx infrastructure, deployments of 100 Gbps systems and continuing upgrades in datacenters.
Suppliers of datacom networking products, led by Cisco, reported steady revenues in early 2012 after a modest growth in 2011. Projections for this market segment look good for the second half of 2012, as Intel is finally shipping next generation processors as of March 2012, starting a server upgrade cycle. Faster servers will require higher speed switches and routers and therefore, more 10G and even 40/100G optics. Shipments of 10 GigE SFP+ transceivers more than doubled in 2011 and we are expecting a 50% growth in 2012. There is no doubt that 40G and 100G optical interconnects will be a great opportunity for suppliers as well. The big question is whether the broader telecom market is going to give a boost to the optical networking supply chain.
Quoting Finisar Chairman Jerry Rawls, “it is not a question of IF the service provider will increase investments into networking infrastructure, but it is a question of WHEN”. The latest spikes in the telecom infrastructure upgrades coincided with the peaks of economic activity right before the crisis of 2009 and right after that. If history repeats itself, the next one should be timed with the global economic recovery as well. While this recovery seems unlikely in the rest of 2012 or even 2013, what would happen to the optical supply chain if the market were to recover in 2014, for example?
Our approach to forecasting the market using the correlation between Internet traffic growth and expansion of the network bandwidth, calculated from shipments of optical interface modules has proven fairly accurate if annual fluctuations were averaged over several years. Our latest report (www.LightCounting.com/reports.cfm), offers an update to this forecast model that averages potential market fluctuations in the years 2012-2016. As an example, the report also discusses a scenario for the optical components and modules market, if the global economy were to slow down in 2012-2013 and to recover in 2014-2015. This scenario is illustrated in the Figure 1 below, which compares historical data and forecast for the Internet traffic growth with growth in core network bandwidth (calculated from shipments of DWDM optical ports) and market growth rate (calculated from SONET/SDH and DWDM transceiver sales).
Figure 1: Modeling of potential economic recovery in 2014-2015 and expected growth for the optical components and modules market.
The figure illustrates several important points and offers a reasonable estimate of a scale for potential market recovery:
Let us elaborate on the last of these points:
This may seem counterintuitive: Why would a 7% increase in network bandwidth lead to a 50% growth in component sales? The explanation is very simple: the network bandwidth is calculated from aggregated capacity of optical interfaces sold over the last ten years, so this is a very large number. Even a small change in the network bandwidth over one year requires a significant jump in this year’s sales.
A more subtle observation derived from this analysis is that as the network becomes larger, small increases in the network bandwidth (in terms of percentage of the total) will require more significant investments, further boosting sales of networking products. It is not a coincidence that a 10% increase in network bandwidth growth rate in 2010 lead to 40% market growth, but a 7% increase in 2014 results in more than 50% growth of the market.
The most fundamental assumption of our forecast for the optical networking industry is projections for Internet traffic growth rate. Small changes to the projected traffic growth rate will lead to significant implications for the market, as illustrated by a simple example discussed above. Unfortunately, historical data on Internet traffic growth is limited and projections for the future vary.
LightCounting has been relying on the forecast for the IP traffic developed by Cisco (http://www.cisco.com/en/US/netsol/ns827/networking_solutions_sub_solution.html). Historical data on traffic growth in 2006-2010, presented in this report, correlates well with data provided by service providers and network operators. Cisco’s projections for the slower growth in the future does make sense in general terms, as growth of majority of systems (such as networks, markets or economies) slows down as they mature (giant stars that eventually explode as supernovas are one of few exceptions). However, the latest update to Cisco’s forecast raises questions.
Figure 2 below offers a comparison of Cisco’s strategic growth projections published in 2011 and updated in 2012, as well as LightCounting estimate, which is used in our latest forecast model. Cisco has increased projections for the traffic growth expected for 2012, based on new inputs from a number of different sources, including many market research companies. The traffic forecast published in 2012 also points to a faster decline of the growth rate projected for 2015-2016. This decline seems to be very dramatic given historical data. It also contradicts to analysis of Internet traffic growth rates recently conducted by IEEE, using data provided by many vendors, including LightCounting (this study will be published by IEEE 802.3 Ethernet Working Group in July, 2012).
Figure 2: Historical data and projections for Internet traffic growth rate
The latest market forecast published by LightCounting is based on a more gradual decline in projections of Internet traffic, illustrated by the green curve in the figure above. This projection remains conservative in comparison with other forecasts, including the ones summarized in the latest IEEE study mentioned above.
One more conservative data point on traffic growth was recently provided by Japan's Ministry of Internal Affairs and Communications, claiming that Japan's total broadband download traffic (not including mobile, business, and consumer-managed IP) grew 24% from November 2010 to November 2011. This does confirm that traffic growth rates in developed markets like Japan are slower, but it is very unlikely that in the next five years the global networks will reach the level of maturity comparable to networks in Japan today. We firmly stand behind the “green line” projections, at least for now…
Detailed forecast for optical component and module sales will be finalized early next week, but preview of the data is available now (www.LightCounting.com/June2012_Forecast.cfm). At this point, the total market is expected to grow by at least 10% in 2012. We are still interviewing the leading suppliers and making adjustments to forecast for specific products. Most of this feedback points towards even higher growth in 2012 so far.
Forecast scenario for a slower market growth in 2012-2013 and recovery in 2014-2015, discussed above, offers an interesting observation. Dependence between changes in growth of internet traffic or network bandwidth and growth in sales of telecom optical components and modules sales is highly non-linear. As a result, small positive corrections to traffic growth projections lead to significantly higher growth of the market, while negative corrections to the traffic growth rate do not make much of a difference. This is illustrated by a simple curve in the figure below. As detailed by our recently published state of the industry report (www.LightCounting.com/2012_SOTIR.cfm), profitability of the optical suppliers is also a highly non-linear function of the market growth rate. The slowdown and recovery scenario would have been perfect for improving profitability of the component vendors. Do not give up on the optical networking market yet. It still holds a promise for a higher growth.
Figure 3: Non-linear dependence between internet traffic growth and optical component sales.
LightCounting, LLC is a leading optical communications market research company, offering semi-annual market updates, forecasts, 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.