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The Starting Line: Glimmers of hope in optical networking

The carnage wrought upon communications hardware stocks this year has been spectacular even by Wall Street's standards, but the pure-optical end might be a refuge.

If you must invest in communications networking stocks these days, the pure-optical end might be the way to go.

The carnage wrought upon communications hardware stocks this year has been spectacular even by Wall Street's standards, and the sector has only worsened in recent weeks.

CNET's Telecom Equipment Index lost two-thirds of its value in the first six months of 2001, with much of the decline coming in June as network-related companies bombarded the news wires with earnings warnings, layoff announcements and a bankruptcy filing from a major data carrier.

Communications carriers can't get enough business to fill their international fiber optic networks, with an extreme example being 360Networks, which last week filed for Chapter 11 bankruptcy protection.

In the past two weeks, bad news of some sort has come from JDS Uniphase, Redback Networks, PMC-Sierra and Nokia. A lack of network traffic means less need for routers, networking chips and components such as lasers.

But if some analysts are to be believed, there's an investor's refuge to be found at the high end. Wall Street research firms point to markets for optical switches and wavelength division multiplexing (WDM)--technology that increases data sent on fiber--as the most resilient parts of the communications equipment industry. These markets include companies such as Ciena, ONI Systems and Tellium.

"We expect spending in the optical-switching and metro WDM segments will remain relatively stable, despite a tight capital market," said CIBC Oppenheimer analyst Rick Schafer in a research report released last week. "These two nascent sectors are just beginning to deliver on their overwhelming value propositions after years of false starts and hype."

Optical networks were all the rage among investors last year. But the reality is that few networks are purely optical, although all-optical networks are generally regarded as cheaper and more efficient than their electronic or hybrid optical/electronic counterparts. But with telecom companies slashing capital-spending budgets drastically this year, no section of the market is immune.

Not even optical-switch leader Ciena.

"While we still expect Ciena to grow 40 (percent) to 60 percent faster than the optical systems market, we believe the market will decline in 2001 and remain flat in 2002," Merrill Lynch analyst Michael E. Ching wrote earlier this month.

"It is now clear to us that no matter how good a product is, it is unlikely that market share gains will be enough to offset the market declines. Once Ciena works through some of their recent contract wins we expect the company to experience some of the same problems that are plaguing the other optical system suppliers."

However, Ciena hasn't stumbled this year yet. As Ching noted, the company continues to win big contracts.

It's not hard to see why Ciena continues to top analysts' earnings estimates, if you believe Robertson Stephens analyst Paul Silverstein.

"While the investment community has expressed increasing concerns regarding Ciena?s ability to sustain its gross margins, we believe--absent a shortfall in revenues--a significant decline in gross margins during fiscal 2001 and 2002 is not necessarily a given," he wrote.

He argues that Ciena's competition remains scant, so there are no price wars to ravage margins. "Pricing pressure in the particular segments of the optical industry in which Ciena competes is relatively more benign--which is not to say that it is benign--than those segments to which Nortel (Networks) and Lucent (Technologies) have the bulk of their exposure," Silverstein said.

If anything, margins could improve because the companies that sell parts to Ciena and its peers have too much inventory, he said. Ciena should be able to squeeze cheaper prices from its suppliers, Silverstein said. "These concessions (from component suppliers) could offset most, if not all, of any pricing concessions that Ciena finds itself providing its carrier customers," he wrote.

In the end, the optical technology of a Ciena or an ONI Systems simply is more important than other communications equipment, proponents will argue.

"Can carriers still afford optical switches? Our checks indicate that spending on optical switches remains a priority for most carriers," said a recent Morgan Stanley report.