Optical Networking: Staying Alive Until 2005 –

The 70s hit “Stayin’ Alive” could be the theme song for most fiber optics companies today. Despite a sharp contraction in the market for optical networking gear over the last two years, substantially more pain lies ahead in 2003 and perhaps beyond. Staying alive till 2005 is the top priority.

When the market peaked at $35 billion in 2000, there were roughly 800 companies in the industry. That number has since shrunk by half, but demand continues to falter, leaving a market big enough to support 80 players at most. So, 2003 will be another year of pronounced contraction and consolidation in fiber optics.

In a market environment in which cost overshadows sheer performance, survivors will have to become near-instant experts at employing a host of cost-cutting techniques, including more economical component design, better component integration and rapid adoption of emerging technological standards. Survivors will also have to diversify beyond the anemic telecommunications sector.

Fiber optics companies will have to fight extremely hard to stay alive in a market that continues to free-fall. The market for optical networking gear declined from $35 billion in 2000 to $10 billion last year, and it will decline to $8 billion in 2003, according to a forecast by RHK Consulting Group. Similarly, the optical components market plummeted from $8 billion in 2000 to $1.5 billion last year and will probably fall to barely more than half that in 2003.

Survival of the Richest

By and large, big public companies have adjusted by shedding factories and jobs. Many startups, by contrast, have been living off equity capital with hopes of a market rebound. That will not happen this year, and growth projections for 2004 are hardly robust.

Clearly, optical startups are under the gun to diversify away from the faltering telecommunications sector. Historically, the Department of Defense has been the primary source of research grants and revenue for the optical industry. Defense applications drove advances in lasers, thin film filters and fused fiber couplers. Now, optical component makers must return to the defense industry to find new applications for their technologies. They must also seek opportunities in areas like as oil exploration and seismic analysis.

Low, Low Prices

Wherever optical companies find potential new industry opportunities or an opportunity within telecommunications, it will be paramount to offer the lowest possible price to get their foot in the door. One route to lowering costs is a merger or acquisition, which offers the potential for greater economy of scale. Another is outsourcing of manufacturing to low-cost China. Yet another avenue is the development of uncooled pump lasers to boost optical signals, eliminating the need for temperature stabilization and, therefore, reducing the cost of the component.

To cut costs further, optical companies have to quickly embrace evolving standards and integrate optical components into subsystems. Standardization is making particularly good progress in the development of transponders and transceivers, which transmit data on an optical stream and strip it out. In the case of 2.5-GByte transceivers, for example, the industry has created standards enabling systems manufacturers to buy these modules from multiple sources and mix and match them.

The initial hybrid integration of multiple optical components has also begun saving money. Widely tunable lasers, for example, combine multiple elements and technologies to produce a laser that can be tuned to as many as 80 wavelengths.

Surviving optical companies must also follow the path of leading-edge players that have begun integrating electronics and photonics to produce superior system building blocks. Until recently, all of the intelligence in an optical system lay in the electronics domain. But there have been significant advances in monitoring and adjusting the performance of optical systems in the optical domain, reducing cost and improving performance by eliminating the need to convert optical signals to electronic signals and back again.

All of these requirements pose substantial challenges for venture capitalists that invest in fiber optics companies. One of the toughest challenges for venture capitalists will be deciding which optical companies in their portfolios deserve continued backing. Venture capitalists must be as certain as possible that the startups they stick with will remedy significant technological obstacles cost-effectively and that their product will sell well. In addition, venture capitalists must help their portfolio companies convince large networking equipment suppliers, such as Cisco, Lucent and Nortel, that the startup will survive and that they can’t afford to ignore the benefits of its product.

Talent Scouts

Venture capitalists must help optical startups with a future to attract top-notch people so that they can ultimately flourish. Not long ago, Silicon Valley was inundated with bright engineers and managers who wanted to work at startups. Today, they’re far more skittish.

Another equally difficult challenge for venture capitalists is that they will probably have to help their startups raise money from corporate customers and other unconventional sources, since it is unlikely that the IPO window will open wide in 2003.

In this black cloud hanging over us is more than one silver lining. Companies that survive 2003 will inherently become extremely disciplined and markedly improve their odds of long-term survival, especially since they will face far fewer competitors in 2004 and 2005. In addition, they’ll be in the market with products that will almost certainly fill significant product gaps among large companies that have scaled back R&D. The worst thing that can happen to a startup that survives 2003 is that it will be bought out by a big public company in 2004 or 2005.

Sanjay Subhedar is a co-founder and general partner of Storm Ventures, a seed- and early-stage venture capital firm that manages $310 million. Previously, Subhedar was the founding CFO of Stratacom (bought by Cisco). He sits on the board of Dowslake Microsystems, an optical component maker, and SMI, a semiconductor components maker.