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Bookham, China, and the Optical Component Market
Recently, I sat down with Giorgio Anania, CEO of Bookham Technology (BKHM). We discussed a number of things, including the emerging competition of Asian optical component manufacturers. My conversation with him was about the industry in general, and not specific to Bookham.
We like to identify macro technology trends and disruptions then determine the best way (if any) to invest in them by following up with individual technical (as in technology, not charts) and financial analysis. Discussions with gentlemen like Giorgio Anania help me start this process. At this time I’m far from finishing it.
One trend I see unfolding is the emergence of Chinese optical component companies. Every company is moving their labor intensive component manufacturing to Asia (including Bookham) either through outsourced manufactuing or directly owned facilities in low-cost labor areas.
There are also new Chinese competitors emerging that not only manufacture in China but also have Chinese SG&A and R&D. These new companies are direct competitors to companies like JDS Uniphase (JDSU), Avanex Corp (AVNX), Bookham, and Finisar Corp. (FNSR).
I walked away from my meeting with Giorgio confident that these new Chinese companies posed little short term threat to Bookham. But this additional investment must pose a threat to someone, and if not Bookham then who? It also led me down the path of analyzing the merits of owning your own fab, as all of these Chinese manufacturers do.
This is our view of the optical component industry business models.
- Vertical – Company owns virtually all resources required to deliver product; from R&D, to some/all component manufacturing, test and assembly, and sales and marketing. Intel is a vertically integrated manufacturer of CPUs, and TI makes their own DSPs.
- Platform – Company owns R&D and Sales/marketing but outsources majority of the manufacturing and test process. Similar to semiconductor fabless model. Platform is an excellent term coined by
![opto_bus[1]](http://static.flickr.com/55/152059886_f663ae7c13.jpg)
The Red Vertical model doesn’t yet exist in the semiconductor industry and has appeared first in optical components because R&D barriers to entry in some markets are low, and labor is a high input cost given current optical manufacturing technology.
The optical market itself is spread into two distinct areas:
- High End: Telecom, lower volume, high specification variability based on end customer and market, boutique, significantly more R&D input. Tunable lasers, EDFA’s, 300 pin MSA’s, Long Reach optics.
- Low End: Enterprise, much higher volume, low/no specification variability, commodity, cut-and-paste R&D. Gigabit Ethernet and Fibre Channel SFPs, 10GbE XFPs, FTTH SFP’s.
Bookham is only focused on the higher end telecom optical modules and assemblies. Most of these require crucial, high IP components within. Bookham makes these components, and even supplies them to some competitors.
The Chinese companies, without exception, lack the capability to build these components and must buy them. They therefore have no pricing advantage in these markets. The InP manufacturing capability Bookham has allows them to differentiate their high-end components. JDSU has this capability as well, though I’ve heard from anonymous sources that they would like to unload it.
The Chinese companies do have a business opportunity in the lower end, where R&D is not as important and components are multi-sourced and readily available. Several of my contacts in the semiconductor industry have indicated that the Chinese simply copy reference designs from their component suppliers and then manufacture them. Their only advantage is cost.
The Japanese suppliers are tough competitors due to heavy R&D investment without regard for return.
Let’s look at how the companies are grouped as a function of target market and manufacturing model. I’ve added in a few examples from the semiconductor market, a market that I believe is identical to optical components in the long term.
![opto matrix[1]](http://static.flickr.com/53/152059883_3e2abdac59.jpg)
The Vertical model is clearly better suited for commodity manufacturing where there are few product variations and high volume. Suppliers that outsource realize less manufacturing cost reduction as volume increases than suppliers that pay the fixed costs on their own manufacturing assets. The higher the volume, the greater the cost gap.
Price is always set at the margin, and the marginal costs of vertically integrated manufacturers are lower than platform companies that outsource manufacturing.
Therefore, any platform company outsourcing the production of low-end high volume products is going to get killed. You don’t see any fabless DRAM, Flash, or high-volume processor companies in the semiconductor business for this reason.
Most high-end optical companies ‘dabble’ in low-end products for the sake of having a broad product line, and I would wager they continue to lose money on these endeavors.
The Chinese vendors have intelligently focused on the areas where their low cost manufacturing will reap the most benefit, and the commodity areas where a lack of astute R&D and SG&A will penalize them the least. I expect Avago and Finisar have insightful opinions on the new Chinese companies.
The battle for the high end will not be West vs. China, but Platform vs. Vertical. Most of the suppliers in the high end market use outsourced manufacturing. Bookham does not, with the exception of some SFPs. As a result, Bookham occupies an odd quadrant.
Why use the Vertical model for lower volume modules with higher Intellectual Property content? Why not accept the higher variable cost model until enough market share is secured to harness the economies of scale of in-house manufacturing?
In the semiconductor market, vertically integrated suppliers that try to supply niche markets continually struggle. These suppliers or the markets they serve eventually go away.
Bookham must be anticipating that they will be the largest volume supplier in the high end either through growth or consolidation.
- If they are wrong, Bookham would need to enter the low-end markets to chew up spare manufacturing capacity- otherwise the fixed cost structure of owned facilities will sink the company.
- If they are right they’ll be the clear #1 supplier for high end telecom components with a manufacturing advantage based on critical mass.
Please share opinions and be constructive. Corrections are welcome as I’ve covered a lot of ground here.
Surprised Giorgio sat down with the author of such a grim assessment. Maybe he agrees with all of it. Between the lines (or maybe not) your analysis suggests that BKHM’s strategy is a desperate gambit, that there’ll never be enough volume at the high end to justify its fixed capacity, and that “down-selling” to the low end is inevitable. Thank goodness for the balance sheet improvement or this company would already be dead.
My question: How is global demand for customized optics shaping up? Does it even exist? What kind of market was there for “high end” components in, say 1999? And now? $3 billion? $10 billion? $50 billion? And how does that compare with the “low end”? A tenth as large? And BKHM sells only $200m of its stuff right now. Does Giorgio know something about this market that know one else does?
On its face it looks pathetic. Your analysis suggests smoke, mirrors, folly.
The only thing grim about my assessment is if BKHM can’t cover the fixed costs of their in-house manufacturing. It’s an if, not a when.
I estimate around 1.5B in high end optics is sold each year. That’s around 10-15% of total transport revenue. A big part of this doesn’t end up on the income statement of BKHM, AVNX, JDSU because the modules are built discretely by the HW manufacturer. This practice is coming to an end, so suppliers like BKHM should see revenue increases as a result of design methodologies changing. An XFP can do a lot more than it used to so custom stuff isn’t as needed anymore.
I don’t write between the lines.
Thanks for your reply. Your presentation was logical, and laid out the structure of the industry in a clear way — readers drew conclusions from it, that’s all. Certainly no accusations here about the author’s intent. You were more restrained in your conclusions, especially for what I am assuming is objective equity research.
Still raises the question whether BKHM’s vertical presence at the high end is viable. What do you think? Sounds like you think it’s too hard or too early to tell.
I think it is too early to tell.
When I look at the analogy in the Semiconductor market, it looks like a bad move. But capital costs dominate there. Labor costs dominate in module assembly and test (at least for now, fix that and you have a winning idea). So maybe the comparison isn’t valid.
I am putting together a plan for an in depth study of this business, an attemnpt to bring some fresh thinking to the debate on optics. Everyone has polarized into the:
1. High end optics is and always will be a money losing business
2. Gilderesque glory of an all optical future.
Interesting and insightful analysis.
A quick comment – Unlike, with the Semiconductor model, the optical module model has an additional layer of complexity. There are very few fully vertical companies. Most companies, whether they are in US, Europe, Taiwan, Japan or China buy their optical components from an outside source, especially for lasers.
Even companies that have their can build lasers are finding it may be cheaper to buy laser from companies like Mitsubishi or AOC that are doing huge volumes of lasers. In Mitsubishi’s case their volumes are being driven by their FTTH business.
As you also mentioned, building optical modules is labor intensive. Things like alignment, test and inspection are still manual processes.
I know next to nothing about optics products, high end, low end, rear end, whatever. But I do think optics as a broadband delivery solution, enabling the telecoms to dominate the data pipe, is a key assumption to even being interested in BKHM common as an investment. I am long the stock, as I mentioned, sorry I held after the initial downdraft on April 17, but now feel I actually have to learn something about its prospects to make the buy-more or hold or sell-all decision in the months ahead. Fact is the stock has been firm at $4 and the upside now substantially outweighs the downside risk. (Famous last words.)
From a US policy standpoint I know Congress will not legislate net neutrality — meaning that the telecoms will be able to charge for certain types of data delivery (video, etc) on an optics pipe, and recoup their investment in optics. This is critical to staying committed to optics, I think. And being long this stock.
This point sure seems like a PR opportunity for Bookham management, which doesn’t seem much interested in articulating much of a message. This is a serious problem for a public company as small and uncovered as BKHM. Sarbanes Oxley doesn’t stand in the way of talking constructively about one’s business. BKHM management is justifiably preoccupied with day-to-day ops, at a critical time, but some good messaging here would certainly help both the company and the stock.
Anyway, just a few two-cent points on why I am sticking to this right now and what the company might be doing better.
This is a very interesting analysis and you make some key points. I would like to add 2 cents, or maybe even less.
1. To succeed on the high end, you need to be a product innovator or the low cost guy. BKHM claims the innovator mantle. Although BKHM talks a good game, they have yet to deliver on innovation. The vast majority of their sales still come from legacy products developed in the past (3 -7 years ago). The new stuff is generally not revolutionary. They intro a new receiver with a VOA. They are finally getting a wideband tunable a couple of years after Intel, Santur and others despite having the technology in house for many many years (and spending the bucks to develop it) and failing in the fundamental execution.
My view: to be a successful vertical integrator you need to execute well and in timely fashion to both justify the added investment of the innovation (leveraged by vertically integrated facilities) and to lead the market and capture share early in the product life cycle.
2. Optics differs greatly from the semicon world. It is highly doubtful that volumes in optics will ever approach semicon. It is forever a niche business. The swift, innovative vertical integrator has a place. The rest will be low cost suppliers
Anyway, my 2 cents.
Employees (2000+) to revenues ratio seems out of whack.
BKHM pledged to cut overhead in its last conference call. Nothing specific has been announced since. What’s going on? These are tough decisions but GA’s got to make them .. where’s the follow through?
Texan Opto I believe has more then 2 cents to contribute to this discussion. Very concise and poignant words.
I believe he was spot on, money to be made in short lived but time product deliveries by companies with some vertical integration.
Anyone in the industry knows where the technology and cost opportunities are but only a handful are even in a position to really capatilize on them. The window is short and competition will close the window within a couple of years.
By the way BKHM stock price clearly shows how well their strategy has worked. By no means dead, but financially crippled, their stock price will continue to fall until it’s true value is revealed. This will take time because as all speculative stock, true value of stock will be reached only after the dust has settled. Dust is long from settling.
Texan Opto also called it right, this industry will ALWAYS be niche. Analogy to semi/disk/and any other consumer product must be taken with a LARGE and painful grain of salt.
Creative thinking is required to understand where to make the money in this industry.
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