Another ECOC is in the books. I have spent the past couple weeks post the second biggest optical trade show in the world digesting the myriad data points and ruminating about how to describe the state of the industry today. As readers know, I really like to draw comparisons between the optical industry and art or life in general. As I considered the chaotic environment of the optical communications industry today, I struggled to come up with a metaphor that really fit the industry to a "T."
However, in many ways, the industry reminds me of the chaotic, post-apocalyptic world featured in the 1980s Mad Max movies that starred Mel Gibson (and that was also depicted in the fourth installment from 2015, Mad Max: Fury Road, starring Tom Hardy and Charlize Theron). In that world, it's every person for themselves. Similarly, in the current optical communications world, every group of participants -- optical transceiver vendors, chip manufacturers, systems OEMs and even end customers like Alibaba, Google and Amazon -- is pitted against one another, even when they are still cooperating with each other on some aspects of their businesses.
The Thunderdome arena featured in the third installment of the film franchise seems like a fitting metaphor for the current state of the optical industry in this way. (I have to admit, it's also fun to imagine Cisco CEO Chuck Robbins or Arista CEO Jayshree Ullal with blown-out hair like Tina Turner's.)
Some supporting data points:
The Ethernet market is in shambles
Based on LightCounting's data and forecast published last week, the Ethernet transceiver market revenue is expected to decline 18% for full year 2019. This would be the steepest decline in the recorded history of the market and the first decline since 2009 (when it declined only 4%). A sell-side analyst report indicating delays of 400G purchases at Amazon knocked down IPHI shares 11% intraday, but the stock almost fully recovered, finishing down only 2% in the same trading day. Finisars datacom business has declined year-on-year for eight straight quarters, including the last quarter before II-VI completed its acquisition.
The hyperscalers are insourcing
As further evidenced by Alibaba's announcement on the first day of ECOC that it would be building its own 400G DR4 transceivers with the help of China-based Hisense, it's clear that hyperscale customers -- who are among the biggest, most forward-looking customers of optics globally -- are increasingly insourcing.
The US trade war with China continues
Similar to the hyperscale companies, Chinese OEMs like Huawei and ZTE are aggressively developing their own internal and domestic supply of optical components, semiconductor chips and modules. Huawei, typically the largest consumer of optical components globally, has been granted a temporarily license to purchase certain components after being added to US Department of Commerce's "Entity List." Tariffs on products made in China shipping to the US went into effect on September 1, and we're hearing some vendors are looking to more aggressively move production outside China. Shipping in the other direction, some US vendors (like connector companies) are seeing essentially all of their business in China disappear overnight as they struggle with tariffs.
The end game has begun: co-packaged optics around the corner
Companies formerly in (or looking to enter) the datacom module business, like Broadcom, Lumentum and Macom, are getting out of the transceiver businesses in favor of shipping optical components and ICs. While the momentum behind 800G modules appears quite strong, an industry consensus seems to be emerging that optics will be co-packaged with ASICs when switch chips hit 51.2 Tbit/s and the Serdes hits 100 Gbit/s. Two weeks ago, Facebook put out a guidance document for vendors regarding potential specifications of co-packaged optics. Of course, there are a lot of technical issues to be solved, and modules will continue to exist for many applications. However, the biggest end users of optics in the world (the hyperscalers) will be early adopters of co-packaged optics. Clearly this is the "end game" that Cisco, Broadcom and Intel are contemplating. There is no doubt this will disrupt vendor relationships and take what was an "arms-length" dating relationship between switch and ASIC vendors to a marriage, of sorts.
The optical space consolidating... with conditions
The acquisition of Finisar by II-VI closed on September 24, allowing II-VI to achieve a new level of scale in the industry and reclaim the crown as the largest optical component vendor in the world (back ahead of Lumentum). However, as a condition of approval, the Chinese trade authority required that II-VI run Finisar's WSS business be run separately, robbing II-IV of a potential source of synergy. The approval by China of the other major pending deal in the industry, Cisco's acquisition of Acacia, seems somewhat in doubt. We've heard more than one institutional investor openly question whether China will approve the deal, and with Acacia shares trading at a 6.4% discount to Cisco's stated cash offer price of $70, capital markets are expressing a non-zero probability that the deal gets approved and closes. It's also worth noting, that the spread on the Mellanox acquisition by Nvidia, also awaiting China regulatory approval, is around 12% at the time of the writing of this article.
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