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Small-Cap Recap: Optical Illusions


The sirens of optical stocks are once again belting out their tunes.

On the back of some good results from MRV Communications (MRVC), Finisar (FNSR) and Ciena (CIEN), "noise" started circulating that the "fiber optics" industry is back in business. Many stocks have already had some head spinning moves, and last Friday a well known TV stock commentator jumped on the bandwagon, giving a "mo-back," "triple buy," "Hallelujah" on FNSR.

I know better than to get in front of mad money tips, but at risk of letting facts get in the way of a good story, here are a few thoughts. (If you'd like to refer to some historical financials and estimate forecasts click here).

First, assuming there is a revival in long-haul optical equipment, as of last Sunday a brand new elephant entered the room in the form of the AT&T (T)/Bell South (BLS) merger. In my humble opinion, this merger is exactly what the optical players did not need at this time. If common sense were not enough to suggest that the type of T/BLS merger wreaks havoc on hardware suppliers, look no further than the press release announcing the merger: it singles out synergies between the two companies' IP networks as a primary source of savings.

Second, the companies getting all the love seem to be the ones which, within the optics food chain, have the most brutal competition and the least prospects for any meaningful sustained profitability. The group includes component suppliers for the equipment that operates the long-haul portions of the networks, and it is crowded with a whole bunch of companies still surviving on the secondaries of the bubble days. They are: Avanex (AVNX), JDS Uniphase (JDSU), FNSR, Oplink (OPLK), Stratos Lightwave (STLW), Newport (NEWP), Exfo Electro-Optical (EXFO), Emcore (EMKR), MRVC, and CIEN.

Without doing an exhaustive financial analysis of each of these names, the bottom line is that current Bloomberg estimate for the group as a whole is for net income of $254 million dollars over the next two years. For such a bounty, the current combined Enterprise Value is $12.4 billion dollars.

Some companies are worse off than others. AVNX for example is burning cash so fast that the Holy Grail of earning 4 cents in fiscal 2007 just might be too far away without another round of diluting financing. JDSU is also losing more money than the GDP of some small countries, but it has a pile yet to lose before running into troubles and, if all goes well, at the end of FY '08 it will have EPS of 9 cents per share. FNSR prospects are outright giddy: revenues are guessed to grow 29% in FY '06 and 20% in FY '07, and the ramp will earn it $4M in '06 and as much as $32M in '07. With a current EV of $1.4 billion look for the blue-light special at your local Super-K. (I have not dug much into FNSR current business, but if history still holds FNSR earnings "conundrum" stems from its symbiotic relationship to Cisco Systems (CSCO), and if past is prologue it's tough to imagine that Chambers will pay FNSR more than the bare minimum to keep its supplier alive).

Other wannabes in this group are OPLK, Bookham (BKHM) (which sports a less than stellar financial past), and STLW, all of which are micro-caps with all the incidental issues that come with that.

Related to the pure optical plays, NEWP and EXFO on the surface do not look like total valuation pipedreams, and might actually be worth digging in a bit more.

Moving to a different layer of the "food chain", CIEN is more of a customer than a competitor to AVNX, FNSR, JDSU, etc. It's the top dog in its business but there is no lack of competition. Here too profits are 18 months away, and one pays an EV of $2.5b for net income of $19M at the end of 2007. This company has diluted itself so much through the years that it will need something close to another infrastructure bubble to earn any meaningful money.

Away from the network core, the more familiar telco tech behemoths dominate the handling and routing of the massive amounts of data destined to travel on the networks' cores. These are the Lucent (LU), Nortel (NT), CSCO and Juniper Networks (JNPR) of the world. The amount of paper wasted on the analysis of these companies has left bald spots in many a forest and there is nothing worthwhile I can add. All things remaining equal, and just from a trading standpoint, JNPR in the $16s seems a reasonable entry point to me.

More opportunities exist in hardware and software companies that handle traffic at the edge of the network, i.e. near the end user. I have suffered for a long time with MRVC. If you are fortunate enough to live in an area with Verizon (VZ) Fiber-to-the-Premises service (FioS), the key to using fiber optics for your phone, ultra-high speed internet, and TV service, is a box that splits the signal for its various uses. MRVC has the lion's share of that market right now. This past quarter its top line results were phenomenal, but alas, it ran smack into the same problem FNSR has: VZ is squeezing the life out of Tellabs (TLAB) (the primary contractor on the FioS project) which in turn is squeezing the life out of MRVC. Sales are terrific but it can't make any money; and, in my humble opinion, VZ/TLAB will continue to ensure that MRVC's sales will be terrific and that it will continue not to make any meaningful money. Furthermore, for part of its business MRVC also slugs it out with the JDSU, FNSR, etc.

MRVC's little brother is EMKR. Its valuation is in la-la land, but it is not out of the realm of possibility that when T/BLS roll-out their FTTP service (and they will sooner than later), they might turn to EMKR and give it its 15 minutes of fame. It would not behoove T/BLS to give MRVC the business and allow it to become the 900lbs gorilla of FTTP end-user boxes.

To avoid getting Hoofy totally peeved at me, things do appear much rosier for the companies that optimize the distribution of data to – and from – the network's edge. My friend and telecom guru Cody Willard has been on top of F5 Networks (FFIV) for the last $30 dollars and continues to think the sweet spot is yet to come. FFIV supplies the software that regulates the flow of data traffic where it matters the most. And the more the traffic grows, the more this traffic cop becomes essential to the process. Tekelec (TKLC) also operates in this general space, but right now it has customer and product "issues".

Personally, I've been on board Akamai Tech. (AKAM) for years and, for my money, it's the single best technology idea I know of. Think of it as the UPS of data delivery: if your data must get to your customer on time and without glitches . . . that's what AKAM can do for you. It's in the sweet spot of growth, has phenomenal leverage to incremental revenues, and the longer it goes without competitors surfacing, the taller the technological barriers to entry, and its first user advantage, grow. And AKAM is not standing still either. Based on what my lay mind can understand, AKAM is now rolling out new software that begins optimizing the management of data while it's still within a network. Google (GOOG) has been rumored as an early adopter of this technology. Lastly, recent reports that ISP's might start surcharging heavy internet users for bandwidth usage, might even resurrect AKAM pre-bubble business plan, i.e. allowing companies to minimize raw bandwidth costs.

So there you have it: all you ever needed to know about a $1 trillion (and counting) infrastructure in 1,375 words. We all know valuations and stock prices are often separate realities; there is nothing to prevent any of the aforementioned stocks from going for the moon (. . . Alice), and I am all for a joyride here and there. But in the spirit of the 'Ville, hopefully this little primer will have all involved playing with their right hand up.
Position in MRVC, CSCO, AKAM, FFIV
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