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2HRS2GO: Optical bubble shrivels -- for now

COMMENTARY -- It doesn't take much to deflate an industry balloon.

Nortel Networks (NYSE: NT) yesterday reported lighter-than-expected optical revenue in the third quarter and ramped down growth expectations. Analyst ratings dropped faster than your average Mike Tyson opponent. And nearly every major stock linked to the optical networking industry is paying for it today.

Applied Micro Circuits (Nasdaq: AMCC), down 22 percent. JDS Uniphase (Nasdaq: JDSU), down 19 percent. Corning (NYSE: GLW) and Ciena (Nasdaq: CIEN), down 16 percent. Vitesse Semiconductor (Nasdaq: VTSS) and Sycamore Networks (Nasdaq: SCMR), down 15 percent. PMC-Sierra (Nasdaq: PMCS), down 14 percent. Not to mention Nortel itself, down 25 percent.

Despite what you might infer from NT's decline, Nortel didn't change the outlook for itself. The company predicted top and bottom line 2001 growth ranging between 30 and 35 percent, or exactly the same range Nortel executives forecast back in July.

Unfortunately, percentage growth for the overall network equipment market is now expected to be in the low 20s, which puts it roughly in line with the out-of-favor PC industry. Nortel = Compaq? A hideous thought for NT investors.

(Although Compaq isn't doing so badly today. CPQ shares were up nearly 6 percent by early afternoon, following the company's better-than-expected earnings report.)

When you think about it, you realize that 20 to 25 percent industry growth isn't so bad. But it's a question of valuation -- optical networking carried the highest trading multiples of any technology sector. They had to come back to Earth sooner or later,and Nortel provided an excuse.

As usual, the wholesale carnage is a bit overdone. Although Nortel's industry outlook could be translated into pain for some optical suppliers, others have pictures of their own that ought to be considered.

Thus, the hurt put on GLW only makes sense if you ignore the rosy outlook issued by Corning almost two weeks ago and burnished even more when the company released quarterly results on Monday. Sycamore Networks (Nasdaq: SCMR) is sufficiently small that it can keep growing at reasonably fast rates. And with Nortel expecting to maintain its own growth independent of the industry, it wouldn't be unreasonable to assume that Nortel-heavy suppliers such as Applied Micro might do alright.

But it's a difficult bet to make, because few investors or fund managers truly understand the optical networking industry. Joe and Jane Investor can make certain judgements about Amazon.com (Nasdaq: AMZN), Dell (Nasdaq: DELL) and Microsoft (Nasdaq: MSFT) because those companies play in markets that directly involve consumers, or at least close to it. Even if you don't use Windows 2000 Server, you probably work for a company that could use it.

Optical networking, on the other hand, is an esoteric land of Fiber Bragg Gratings, pump lasers, wavelength division multiplexers and Peter-Lynch-knows-what-else. I doubt one in 100 investors could explain JDSU's full product line. I certainly can't.

Unlike PCs, where we have many ways of judging demand, the only way to measure optical networking growth is to look at capital expenditure for corporations and communications carriers, and even then, few of those companies break out detailed capex lines that list specific expenditures for routers or signal boosters.

So to a large extent, we have to take the suppliers' word for it when it comes to growth. Nortel, Cisco Systems (Nasdaq: CSCO) and JDS Uniphase (Nasdaq: JDSU) say fiber optic networks are hot, so people buy into them, hope for the best and give them the best valuations. And when the best turns out to be good-but-not-great, investors flee.

I wonder where they'll put their money. Optical networks may be a tough field to grok and it may have a reduced outlook, but no tech sector is growing faster. 22GO>