Innovation depends on consolidation

After several years of huge and painful industry retrenchments and restructurings, there are increasing signs that communications investment is returning, and that markets are growing again. Has the communications industry finally turned the corner?

Unfortunately for the optical-component sector, the answer has to be "only partly". While any recovery is welcome, little has really been done to address the fundamental problem facing vendors: crippling price competition as the result of a hugely overcrowded industry.

About 25 component vendors with sales of more than $10 million per quarter, plus numerous start-ups, are competing in a $3 billion annual market. Though the market has probably entered a five-year cycle of low-double-digit growth, the revenue pressures at the telcos will continue to be passed down to the equipment OEMs, which will seek to consolidate to maintain margins. All this adds up to more pricing pressure on optical-components companies, unless they too start consolidating.

At equipment vendors and telcos, this consolidation is clearly beginning to accelerate. It all starts at the telcos. The erosion of revenue from their voice traffic is speeding up and is no longer hidden by growth in wireless services. Their response is to deploy new technologies that can significantly reduce operating expenses and bring in new revenues, such as reconfigurable networks based on packet-switched traffic, converged broadband services, and fiber-to-the-whatever (FTTX). This has increased the need for investment at a moment when telcos finances are already under pressure. So they resort to mergers to generate economies of scale and to put continuing pressure on their suppliers, the optical equipment OEMs.

Recent telco mergers, such as Verizon-MCI and SBC-AT&T, will probably act as a trigger for further restructuring. Pressure has moved down to the equipment OEMs, and the Lucent-Alcatel merger is likely to stimulate similar consolidation. The result - fewer but more powerful downstream customers - will further weaken the hand of the leading optical-component players if they do not respond. Put simply, this industry is not grabbing the opportunity to consolidate ahead of its customers and move decisively to recreate pricing advantage and economy of scale.

There are two to three times more optical-component vendors than a stable, profitable, innovative market can reasonably support. The number needs to come down to about half-a-dozen or so leading players. Contract manufacturers aside, there are three types of players that would plausibly participate in such a drastically reduced population.

The first would be product-focused players that are strong in narrow, well-defined niches. Over time, they are likely to lose contact with the major OEMs, which increasingly prefer to deal with a small number of broad-based strategic suppliers. But they can generate a profitable business supplying the "horizontal" players offering a broader supply of optical components. They are the "sub-suppliers".

A second type would specialize in component and module design and outsource almost everything else, but remain broad-based suppliers to the OEMs. They would buy chips from, say, Japanese suppliers, assembly from contract houses, and specific components from sub-suppliers which they then incorporate into modules. This leaves a lot of value in the hands of the outsourcers and the components-focused players, but allows flexibility and low capital costs, and has obvious appeal to smaller vendors that lack the resources to engage in large-scale fabrication.

Near-term, they could cut costs very quickly. Longer-term, however, the lack of added value would likely make them uncompetitive in attacking the larger commoditizing sections of the marketplace. Over time, these "variable-cost-structure channel players" would probably focus increasingly on exploiting niches, which may reduce their relevance to the key OEMs.

The third remaining type is the broad-based vendor, vertically integrated from semiconductor technology to finished optical components, modules and subsystems. The major part of the value chain is kept in-house, allowing such companies to use low-cost production and to win business based on optical semiconductor innovation and leading-edge chip fabrication - the major source of differentiation to date. Necessarily available only to the large players, this approach depends on having sufficient component volumes to cover the high fixed costs of vertical integration, and is less flexible than the variable-cost play. However, given scale, this business model can become the most profitable.

Bookham is of this third type, fully vertically integrated from semiconductors to subsystems. Already quite profitable at the margin (i.e. incremental sales provide high incremental profits), Bookham can become very profitable if it participates in a consolidated industry structure that provides it with high volumes over which to spread the huge fixed costs.

Japanese vendors have always taken this approach. They have a long-term view and continued to invest aggressively in semiconductor technology even during the downturn. Most western players (Bookham is one of the exceptions) haven t done this. The result is that the Japanese vendors are bringing out new devices just as the market is beginning to revive - and vendors without fabs are increasingly beginning to buy from them. This can only strengthen the vendors in Japan by increasing their manufacturing scale.

Those Japanese companies have a further scale advantage. Unlike western component-makers, they are not standalone companies but part of major conglomerates, such as Fujitsu, Mitsubishi and Sumitomo. So the cost of their optical-component research and production facilities is offset by selling into all of the markets where the mother company is present - DVD read/write lasers for consumer electronics, industrial lasers, and more. This guaranteed end-user market is crucial for scale.

In the West, as a standalone industry we need to be able to do the same. As an independent company, Bookham has to recreate that captive market by investing in areas that can use its fab capabilities and chip designs, exploit its existing assets, and win those customers on its own. We have, for example, directed our telecoms EDFA laser-pump technology into industrial-laser applications - a growing and profitable market. Our thin-film technology used in telecom is being targeted at life sciences and consumer market displays. Our recent acquisition of Avalon, which is strong in optical sensing and short-reach datacoms applications, is another step in this strategy of increasing our technology capabilities and market opportunities, all feeding into the same fabs and generating greater effective scale.

Compelling financial logic makes restructuring inevitable, as well as a smarter spreading of the asset and knowledge base of the optical-components players beyond telecom into many other markets. But it is not just the optical-component industry that needs this change - so do the OEM customers.

Differentiation allows profitability, whether it is optical-components companies or their customers - the network OEMs. OEMs will have to be increasingly aware of optical-component technology coming down the pipe in two or three years, so they can back the right horse. With fewer, more powerful component vendors, the interdependence between them and OEMs will increase sharply. This will make it much easier to marry component-development roadmaps to network-product roadmaps, and bring innovation to market quickly, cost-effectively and with less risk. Early adoption and two-way commitment are prerequisites.

Innovation will be crucial to the realization of next-generation networks and the new-era communications they promise. But this will be maximized only if players from both the component and equipment sides of the business know that the other is still going to be there several years down the line - and they both need to make sure it happens.