Biting the component bug

The laws of supply and demand are being challenged in the optical component space. Component vendors are enjoying a healthy run on Wall Street and, at the same time, successfully gobbling up their competitors or other companies to expand their product lines.

Component suppliers are the cause of frustration and jealousy for optical equipment vendors. The latter view the development and production of optical components as problematic, tedious tasks that don't have much bearing on their bottom line. But some components, especially the newest ones, are integral to their systems and are in short supply.

To compensate, equipment vendors such as Alcatel, Lucent Technologies and Nortel Networks have their own optical component businesses. But the resources required to operate those businesses can be heady. As a result, many system vendors rely on outside vendors such as JDS Uniphase, Pirelli and SDL for components.

"If we could buy everything, we would," said John Roth, vice chairman and CEO of Nortel, in reference to optical components. Nortel, which maintains a component division, would prefer to buy optical components than tie up capital to build them, he said.

To gain leverage, system vendors are using a tactic that providers often employ on them: They are playing component suppliers against each other to fill orders faster and develop more powerful products to secure future contracts.

"It's great to be able to force suppliers to add more features and force pricing, too," said Michael Howard, principal at Infonetics Research.

But it doesn't always work. Mergers and acquisitions are becoming more commonplace in this space - JDS Uniphase has swallowed competitors E-Tek Dynamics and SDL. As a result, supply channels are narrowing, and equipment vendors are quickly losing their power to leverage.

"We are concerned about the level of consolidation," Roth said. "That's why we are investing money to ensure we have the channels of supply."

Nortel revealed plans to invest $1.9 billion in itself to ramp up production capacity; $1.2 billion of that will go toward the expansion of production capacity for optical components. Nortel currently uses components from its own division and from outside suppliers to build its systems. With the added production capacity, Roth hopes Nortel also will sit on the supplier side.

Thus far, Nortel has guarded against component supply constraints, but it won't stay that way for long, Roth said. Theoretically, the company's internal investment will minimize those constraints.

Nortel is not the only company to bolster its internal component division. Alcatel is ramping up, too.

"To keep up with market demand pace, Alcatel Optronics is constantly investing in both R&D and production capacity," said an Alcatel Optronics spokeswoman. Alcatel Optronics has tripled capacity in the last four years, and its Optronics 2000 program will increase manufacturing capacity sixfold, she said.

Despite the projected growth of equipment manufacturers' components divisions (see figure), they are expensive to operate. While vendors are more attuned to the component shortage, many plan to spin off or sell their optical components businesses.

There are two possible reasons for this sudden shift. Component vendors are experiencing high market capitalizations, and producing components in short time periods is cumbersome and expensive.

In addition, the fact that more emphasis is being placed on software innovation rather than hardware and components may force equipment vendors to bail out of the component business.

"On one hand, you might want to divest the manufacturing to concentrate on higher-level assembly of [equipment]," said John Lively, senior analyst of optical components for RHK. "On the other hand, certain optical components can be critical."

Lucent recently revealed plans to spin off its microelectronics and components business. That was followed by Nortel's now-abandoned deal to sell its component business to Corning in exchange for 50% ownership in the company. Alcatel is trying a different strategy, proposing a tracking stock for its component division. That would emphasize the market value of the component division.

"If the market cap continues to be so high, they will all want a piece of it," Lively said.