Lackluster returns last week for Nortel Networks Corp. threw the entire optical-electronics industry into a panic and precipitated concerns that the fiber-optic landscape may be getting soft at the top.

Nortel, the No. 2 optical-equipment manufacturer behind Cisco Systems Inc., triggered some soul-searching within the industry when it fell short of investors' lofty expectations in a market already jinxed by the poor performance Lucent Technologies Inc. turned in recently.

Nortel's third-quarter results came amid growing uncertainty in the telecommunications-services sector, and again raised questions as to how well telecom and datacom-service providers, OEMs, component suppliers, and contract electronics manufacturers are managing their forecasting systems.

"Does Nortel's slowing in optics reflect slowing spending by [telecommunication and networking] carriers?" asked Thomas Astle, an analyst at Merrill Lynch & Co. Inc., New York. "This issue has had a big impact on the equipment space for over a month, and Nortel's issues might support this view."

An overview of Nortel's fiscal shortfall indicates that the company and its customers are having problems gaining visibility into the supply chain. Third-quarter revenue of $7.3 billion was about $400 million below some analysts' estimates, but the real shocker came in the optical-equipment unit, where sales rose 90% from the year-ago quarter but fell 5% to 10% sequentially. The decline was due to equipment-inventory overload at Nortel's customers and the company's inability to secure enough skilled staff to install optical systems, analysts said.

Nortel lost almost one-third of its stock value on the news and dragged down investment markets across the globe. The ground shifted under the entire optical industry, with most companies in the sector losing up to 25% of their market value on Wednesday. Nortel, SDL, and JDS Uniphase led the downturn with all three dropping to less than half of their 52-week highs.

"Nortel's results had one big surprise-optical revenue declined sequentially. Ouch!" Astle said. "Clearly this event has shaken our confidence in the company's visibility, and we're not completely sure if we should buy into the explanation provided."

Investors could be responding to what may be the rumblings of empty stomachs at the top of the telecom-industry food chain, analysts said. Investors may be drawing a link, however tenuous, between the optical-equipment and components market and the larger telecom world, where service providers like AT&T Corp., WorldCom Inc., and the Baby Bells are locked in a struggle for market share.

The problems facing service providers' like AT&T, which plans to break up into four separate entities, cannot be isolated from those of equipment suppliers, which in turn, cannot shield their suppliers from any demand weakness from above, analysts said.

The closest analogy in this instance can be drawn from the wireless-equipment market, according to Bill McClean, an analyst at IC Insights Inc., Scottsdale, Ariz.

"Cell-phone producers in 2000 planned to sell 520 million cell phones. [They] ordered ICs and components to match this 'plan,' but will sell about 100 million less-still a 50% growth rate over 1999," McClean said. "It doesn't matter how fast a market's growing if supply is outstripping it."

The supply-chain management difficulties facing the optical-equipment industry may be complicated by the recent sharp increase in capital expenditures at the telecom and networking carrier level. In 1999 and 2000, telecom-equipment OEMs raised their capital expenditures by 22% and 33%, respectively, instead of the 9% and 6% increases forecasted by researchers.

The higher capex was a result of moves by the likes of AT&T, Covad, Level3, Nextel, Qwest, Sprint, Verizon, and Worldcom to upgrade their networks in order to provide voice and data transmission over the Internet and cable lines. These access and service providers have largely chosen fiber-optic networks because of their higher bandwidth and faster transmission capacity. However, these companies, which make up the bulk of the customer base for fiber-optic-equipment OEMs, are facing a declining consumer telephony industry while intense competition for market share is creating a chill within the sector.

WorldCom, Clinton, Miss., further muddied the outlook for telecom companies last week by announcing higher third-quarter revenue that nevertheless was weaker than expected. The telephone and data-services company said revenue rose 10.7%, to $10 billion, about $500 million short of some analysts' estimates.

Until recently, investors who assumed that the fiber-optic sector was immune to the weakness in the larger telecom market pushed the leading OEMs' and suppliers' stocks to the stratosphere. Shares in JDS Uniphase Corp., Nepean, Ontario, for instance, surged 354% in one year, to $153.38 from $33.75, while San Jose-based SDL Inc.'s stock witnessed an even more spectacular 881% hike, to $460.50 from $46.94 during the same period. Shares of Corning Inc., Corning, N.Y., the No. 2 global optical-components supplier, rose 399%, to $113.31 from $22.69.

The high valuation given optical-components suppliers and the equally lofty premiums that the leading players were willing to pay for their smaller rivals (JDS Uniphase's purchase of SDl was initially valued at $41 billion) is fueling growth within the industry. The optical market is getting crowded as some suppliers divert resources from their traditional markets to the sector, which Merrill Lynch estimates will balloon by 2003 to $22 billion from about $5 billion in 1999.

Nortel, WorldCom, and AT&T's problems may have spooked the investment markets, but bigger problems are lurking if the fiber-optic-equipment market begins to slow down, according to Nicholas Economides , a professor of economics and a telecommunications industry expert at New York University's Leonard N. Stern School of Business. AT&T's decision to split its operations will reduce the pressure on the Baby Bells to deploy DSL lines in a strategy to protect their home turf from their bigger rival, Economides said.

"AT&T's cable unit created a threat to the monopoly of local telephone providers and forced them to push hard to deploy DSL," Economides said. "That threat has been postponed or eliminated. These companies won't be in such a hurry anymore."

That feeling was hard to shake on Wall Street last week despite JDS Uniphase's positive results, which temporarily restored investors' faith in the optical sector.

"If there is a slowdown in the optical- networking market, someone forgot to tell JDS Uniphase," Merrill Lynch's Astle said. "[But] how much visibility does a component supplier like JDSU have? Generally, component companies would have less visibility than an OEM systems maker who deals directly with the end user."

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October 30, 2000