Vertical Integration Takes Its Lumps

The topic of vertical integration was fair game for discussion at last week's OFC/NFOEC, but lots of people at the show were skeptical about it happening.

We're talking about the idea of a systems company either acquiring an optical components company or building its own components division. The idea of building one's own optical modules out of purchased components counts, too, but on a lesser scale.

Some executives and analysts claim there are OEMs seriously considering that route, as Light Reading reported just before OFC/NFOEC. (See Can Vendors Build Their Optical Components? and OFC/NFOEC: Mergers Haven't Gone Far Enough.) It would reverse the divestment trend that's dominated since 2002.

What we're not talking about is the vertical integration where a components or subsystems company owns its own manufacturing. That's already being tried -- and is working for Finisar Corp. (Nasdaq: FNSR) and Oclaro Inc. (Nasdaq: OCLR), said Paul Bonenfant, an analyst with Morgan Keegan & Company Inc.

The one systems company that everyone can believe would make its own components is Huawei Technologies Co. Ltd. It's just a very Huawei thing to do. (Huawei didn't respond to a brief pre-OFC/NFOEC query about this.)

But the thought of anyone else doing it? Most people at the show were skeptical.

"If you're an OEM, is your best strategy to imitate Huawei? You're not going to out-Huawei Huawei," said Craig Iwata, manager of corporate marketing for JDSU (Nasdaq: JDSU; Toronto: JDU). The only company he could envision trying it would be ZTE Corp. (Shenzhen: 000063; Hong Kong: 0763).

Complete vertical integration seems out of the question, just because the technologies behind optical networking are so widespread.

"What's being underestimated is the cost of doing that," said Terry Unter, CEO of Mintera Corp. "You have micro-optics, you have indium phosphide, you have other compound semiconductors... I doubt any TEM [telecom equipment manufacturer] can build volume to amortize all those technologies."

"It's extremely expensive to make those investments," said Tom Fawcett, director of marketing for JDSU's transmission modules unit. "A middle ground we see is people pulling in at the component level and doing their own integration."

But equipment manufacturers would have a hard time building up that expertise, Unter claimed.

Of course, it's natural that module and subsystems vendors would reject the idea of a vertically integrated systems player, as it could hurt their businesses. And it would dilute their role as the bastions of innovation in an age where the systems vendors have had to skimp on R&D.

But even people without a direct stake in the game didn't like the idea. "Usually, you do it to get control of fixed costs," said Andrew Schmitt, an analyst with Infonetics Research Inc. "For the equipment guys, getting vertically integrated isn't going to help the cost structure."

Why do it, then?

The theory that spurred the original Light Reading article is that systems vendors are running out of ways to stand out. Optical modules, for instance, all conform to multisource agreements (MSAs). That saves the systems vendors some money, but it also means they're all pulling lookalike optics out of the same pile. Maybe, the theory goes, they could find a new spark by building from the components up.

The idea particularly works with new generations of technology. Nortel Networks Ltd. built its own optical modules for 100 Gbit/s, because the pieces weren't available yet, and the company has a headstart and a Verizon Communications Inc. (NYSE: VZ) contract to show for it. (See Verizon Switches On 100G in Europe.)

One fan of vertical integration is Ray Conley, a partner at Palo Alto Investors . He noted there could be systems-design advantages to owning one's own components. (See, again, OFC/NFOEC: Mergers Haven't Gone Far Enough.) And he thinks it's the best way to avoid competing on price alone.

"Huawei and ZTE are taking advantage of commodotization of components and are winning because it's a price game. If the other vendors want to have an advantage in a full value-add game, they're going to have to have full vertical integration," Conley said during the The Optical Society (OSA) Executive Forum, a pre-OFC/NFOEC gathering.

— Craig Matsumoto, West Coast Editor, Light Reading