We attended the annual Optical Fiber Communications (OFC) technical conference held in San Francisco this week and over the course of two days visited with 15 optical components and systems companies. In this note, we preview five trends encompassing the optical industry, based on our discussions with leading voices of the industry, and offer a deeper view into each of them: unabated demand for fiber connectivity and bandwidth; photonic integration, including silicon photonics; line-side 100G coherent pluggable optics; packet-optical convergence, including software-defined networking (SDN) and network virtualization (NFV); and the road map for 400G and beyond.
In our coverage, we are most positive on Ciena and JDSU, bullish on Infinera (but with upside more limited in the near term despite the strong momentum), and remain neutral on Finisar. Ciena is benefiting from the favorable capital expenditure backdrop and favorable product mix (25% is non-telco), the Project VIP and metro opportunity at AT&T (T $32.35; Market Perform), sustained 100G buildouts at Verizon (VZ $46.03; Market Perform) (both AT&T and Verizon are expected to grow again this year), and a metro project with CenturyLink (CTL $30.49). JDSU is beginning to see strong orders from China (in test and optical) and is the only vendor going against the trend during the last year.
Infinera is bucking seasonality in the March quarter (revenue expected to be up 1% sequentially at midpoint) and ramping up at CenturyLink and a bandwidth wholesaler, which we believe is Level 3 (LVLT $37.22). Lastly, on Finisar, given generally constrained demand at Cisco (CSCO $21.52; Outperform) and subpar performance in telecom, we prefer to see more evidence of improved telecom demand and margin impact before getting constructive on shares.
Several component vendors (Emcore [EMKR $5.15]) and a contract manufacturer (Fabrinet [FN $19.24]) noted pent-up demand from China for 100G transmission.
Data center build out continues unabated as copper is being replaced by fiber and more bandwidth is added. The alternative carriers’ capital expenditures have been growing at a 22% compound annual rate in the last six years (see our July 2013 industry report) and has likely accelerated recently with Web 2.0 vendors raising capital expenditure expectations.
Despite the notoriously tough quarter for the industry given telecom budget-setting and annual price negotiations, operators continue to spend on backbone upgrades, underpinning our thesis for a shift from wireless to wireline capital expenditures in North America. In Europe, with capital expeditures cut in half since 2008, vendors are beginning to see some pockets of strength and a slow reversion to the mean.
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