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Optics remains the weakest link in the industry supply chain

LightCounting releases State of the Optical Communications Industry Report

Optical component and module vendors had the lowest profitability across all levels of the industry supply chain for the last 15 years. The group’s average profit margin improved in 2016-2017, reaching 9%, but dropped to below 4% in 2018, as illustrated in the figure below. In contrast, profits of all the other types of companies in the industry improved last year. Demand for networking products, including optics was very strong in 2018. What is the problem with optics?

The main problem is that optics is a tiny part of a very large industry. Combined revenues of ICPs and CSPs are more than $1.8 trillion, and those of network equipment manufactures and semiconductor IC vendors are more than $300 billion and $200 billion, respectively. Sales of publicly traded manufacturers of optical components and modules reached just $7.2 billion in 2018. The net income of the optical component and module vendors was $0.27 billion, versus $111 billion for the CSPs in 2018.

It’s a fact that size matters when it comes to negotiating pricing. Sharp price declines for many optical products and especially for 100GbE transceivers erased profits in 2018. Shipments of 100GbE transceivers more than doubled, exceeding 6 million units, but revenue increased only by 14% last year. In comparison, sales of 100GbE products increased by 150% and 45% in 2016 and 2017, respectively.


Figure: Sales-weighted Average Profitability across the Industry Supply Chain

 



Supply shortages of some of 100GbE products helped sustain prices in 2016-2017 and resulted in improved supplier profitability. This is not the first time that profits of the suppliers picked up when their products were in short supply.

Large customers are concerned with the small size of their optics suppliers and they are terrified of shortages. Each time there is a shortage, customers end up buying a lot more products than needed and then cancelling their orders abruptly as they realize that the shortages are gone and their inventories are too high. This cycle leads to sharp fluctuations in demand.

The inability of suppliers to control pricing also stems from the lack of unique products and designs that can be protected by patents. Finisar was able to enforce patent violation claims against Source Photonics a while ago and more recently against Gigalight, but these are exceptions. A majority of products and designs conform to multi-source agreements (MSAs) which invites competition. FOIT has been able to reach higher profitability by focusing on custom made, proprietary transceivers, such as 40GbE and 100GbE BiDi modules.

Another “wild card” in the market is the trade war between China and the U.S. Tensions are reaching new heights as this report is published and it seems likely that U.S.-based suppliers won’t be able to sell products to Huawei, at least, for an unknown period of time. This is problematic for the majority of optical components suppliers, but companies like NeoPhotonics that rely on Huawei for close to 50% of their revenues are in real danger. It is very likely the market’s growth and vendor profitability will reach new lows in 2019 prior to rebounding in 2020.

Demanding customers, shorter product lifecycles and the large investments required to support development of new products all present continuing challenges to suppliers. Start-ups will continue to test the dominance of established vendors, and new technologies like Silicon Photonics (SiP) will accelerate innovation. In spite of this, we believe many suppliers of optical components and modules are on track for sustainable profitability in the next few years. Established suppliers, including Lumentum and Oclaro have already refocused their businesses. NeoPhotonics continues to do so. New entrants such as Acacia and Innolight rely more on outsourced manufacturing, introducing new integration, packaging and testing technologies. Projected demand for high-end products (200GbE, 2x200GbE, 400GbE) will continue to present new opportunities for these suppliers. Whether suppliers will be able to make a profit remains to be seen. Future shortages may help, but the customer may choose not to deploy next generation optics until they are convinced that shortages in the supply chain can be avoided.

Lack of confidence in optics suppliers may be one of the reasons Cisco acquired Silicon Photonics (SiP) start-ups Lightwire and Luxtera. Ciena, FiberHome, Juniper, Huawei and ZTE are all investing more in internal manufacturing of optical components and modules. Intel is back in the optical transceiver business again. Arista’s founder Andy Bechtolsheim spends most of his time with the optical industry, recognizing that this is the weakest link for the future of his business. Another motivation for recent interest in SiP startups may be that the optics is becoming an ever-larger portion of the bill of materials of networking systems, and a third could be the eventual co-packing of optics and ASICs, requiring a more intimate design relationship. All these factors would lead to equipment makers to want to have more control over the optics they use.

There has to be a better way. Lumentum sold its datacom transceiver business to Cambridge Industries Group (CIG) in March 2019, refocusing the company on its higher margin DWDM products and laser chips business. Using semiconductor laser technology to serve multiple markets, such as communications, facial recognition sensors, LIDARs, medical and industrial applications seems to be Lumentum’s strategy for the future. Once the acquisition of Finisar by II-VI Photonics is closed, the new company is likely to refocus its business as well. Serving multiple market segments using the same core chip technology works well in the semiconductor IC business. Can this work well in the laser business?

The State of the Optical Communications Industry Report provides a holistic analysis of the global communications industry, during a period of unprecedented growth in demand for broadband connectivity and the rise of Cloud companies. It examines business strategies of traditional telecom service providers and Cloud/Web2.0 companies, as well as their suppliers of networking equipment and optical/electronic components.

A detailed analysis of revenue growth and profitability across different levels of the industry supply chain in 2010-2018 is used to identify challenges and opportunities for the future. The report also includes a review of the latest mergers and acquisitions and their impact on the market landscape.
The report takes a deeper look at suppliers of optical components and modules, providing market shares of leading vendors sorted into the several categories (top 3, top 4–6, top 7–10, and other vendors). It includes data on diversification of the top 12 leading suppliers of optical transceivers in the Ethernet, Fibre Channel, WDM, FTTx, Wireless, and Optical Interconnect market segments. Many of the leading component vendors shared confidential sales data with LightCounting to support this study.

The success of Chinese equipment and component suppliers is discussed and many Chinese optical component and module vendors are profiled.

More information on the report, including the table of content and database template are available at: https://www.lightcounting.com/SOTIR.cfm

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