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Why is sustainable profitability so challenging to achieve in the optical components and modules business?


LightCounting releases its annual State of the Industry Report


“Loss” may be the most often used term in quarterly earnings calls of optical component and module vendors. NeoPhotonics surprised investors last week by reporting a profit of about $100,000 on more than $80 million in sales and their stock went up by 30%. To be fair, the company’s financials looked better on a non-GAAP basis and the investors really liked the significant increase in the gross margin, but can we expect more in terms of profitability?

The average net margin of publicly-traded optical component and module suppliers remains embarrassingly low in comparison with the rest of the industry supply chain, and it often dips into the negative territory.



However, the average net margin hides a huge variation in profitability among the vendors. For example: Accelink and Finisar reported positive net margins for each of the last five years. Several smaller vendors, such as AFOP, CoAdna, O-Net and Oplink reported positive results for at least three of the last five years. However, the continued poor performance of JDSU, NeoPhotonics and Oclaro keeps pulling the average net margin down to around zero. Management of the poorly performing vendors certainly recognizes this problem and is working hard to restructure their businesses, but finding a solution is taking longer than anyone expected. Many privately-held optical component and modules suppliers are probably facing similar challenges today or may encounter them in the future as their businesses grow.

What is also alarming is that net margin at a large and well diversified supplier like Finisar remains volatile. It reached 10% in 2010, but fell to almost zero in 2012, bounced up to 8% in 2013 and fell down to 3% last year. Why is it so challenging to maintain solid profitability in this business?

It seems that an optical component and module business can be very profitable from time to time, but it is hard to avoid periods of reduced profitability. Can this be related to the variations in net margin of a few main products during their lifecycle? It is hard to get actual data on manufacturing costs of optical products, but costs should fall sharply as production yields improve, leading to a spike in net margin.

Ideally, the period of high margin for a new product should last several years to pay for development costs of the product and fund future R&D work. In reality, the periods of high profitability in a product lifecycle may be much shorter. If too many suppliers start shipping the same product in volume after reaching high yields, the pricing falls too quickly, and profit margins are eroded. Some of these vendors may be trying to win business at any cost, disregarding profitability. Needless to say, such lack of discipline leads to an unsustainable situation, jeopardizing the future of the industry. A few customers benefiting from this unsustainable business practice today may regret this in the long term, if their bets on new disruptive technologies and suppliers fail.

The FTTx transceiver market in 2010-2014 offers an illustration of such a “dead-end scenario”. Too many suppliers entered this fast growing market in 2010 and pushed pricing to an unsustainably low level by 2012 as shipment volumes for EPON and GPON ONU transceivers peaked. Many vendors exited the market in 2013-2014. The few remaining suppliers of FTTx ONU modules are making a profit by selling other products based on the same manufacturing platform. Developers of potentially disruptive products, like OneChip, were forced to shut down. Has anybody benefited from this outcome? Wouldn’t customers purchasing next generation FTTx products be better off having more suppliers and technologies to choose from?

How can anyone reach sustainable profitability in a market subjected to such rapid erosion of new product margins?

LightCounting’s State of the Industry report discusses several winning strategies and considers 10GbE and 40GbE optical transceiver products as examples, highlighting challenges for suppliers of 100GbE modules. The report also provides a holistic analysis of the global communications industry, and the factors affecting profitability at each level of the value chain. It examines the profitability and long-term strategies of traditional telecom service providers, as well as the newer Internet content providers, and their respective equipment and component suppliers. The success of Chinese equipment and component suppliers is evaluated and a number of Chinese component vendors are profiled.

This report also takes a deeper look at the SONET/SDH, Ethernet, Fibre Channel, WDM, Wireless, Optical Interconnect (AOC/EOM) and FTTx segments within the optical components industry, providing market shares of leading vendors sorted into several categories (top 3, top 4-6, top 7-10, and other vendors), illustrating the fragmentation of these market segments. Data on the diversification of the top 10 leading suppliers of optical transceivers presented in this report suggest that most component suppliers remain highly specialized. Many of the leading component vendors shared confidential sales data with LightCounting to support this study.

ABOUT LIGHTCOUNTING MARKET RESEARCH
LightCounting is a leading optical communications market research company, offering semiannual market updates, forecasts, and state-of-the-industry reports based on its analysis of primary research with dozens of leading module, component, and system vendors as well as service providers and other users. LightCounting is the optical communications market’s first choice source for the accurate, detailed, and relevant information necessary for doing business in today’s highly competitive environment. For more information, visit: www.LightCounting.com or follow us on Twitter at @LightCounting.