AltAsset, October 16, 2002
The Israeli optical industry: Has the light faded?

“I had 30 years in the communications industry, and 29 of those were great,” as Rich McGinn, former Lucent CEO, now partner at RRE Ventures recently described the state of the industry. In 2001, service providers cut their Capital Expenditure spending (CapEx) by as much as 50%, and optical equipment vendors have watched their shares drop in value by 90% on average. Optical Communications startups are also beginning to feel this pain, and it will get worse. Let us examine how this developed and what are its implications for the once very promising Israeli optical communications industry and its investors.

The depth of the current crisis in the optical sector was caused by the concurrent appearance of two events: first, the 1996 Telecommunications Act that deregulated the Telecom industry in the US allowing for the creation of intense competition in the wireline Telecom sector, and second, the optical technology hype brought forward by DWDM and 10Gb/s development.

Following ‘96, both new and incumbent carriers, encouraged by very favorable financial markets, began massive overbuilding of optical networks to compete in a newly deregulated and highly competitive environment. Most were counting on exponential growth in data traffic, due to fast adoption of Internet by businesses and households, to create a surge in demand for communications capacity. Unfortunately, while the boom in data traffic materialized (data traffic grew from <10% of total telecom traffic a few years ago to >50% in 2001), revenues from data has been almost negligible. As a result, service providers revenues have remained flat in the last two years, in sharp contrast with the level of capital spending of carriers which peaked at >30% of revenues in 2000.
At the same time, optical technology has experienced a major hype period in which a lot of money has poured into optical companies. This fueled the creation of a huge number of optical startups (there are a staggering 800 component companies already) and has brought both public and private companies to sky-high valuations with frantic M&A activity.

These two effects have created huge network overcapacity especially in the long haul and thus, a drastic drop in the demand of optical equipment. At the same time, a large number of well-funded companies need to compete for the much-reduced number of dollars spent by the service providers. This reality was clearly felt at the recent OFC conference in Anaheim, the main optical communication event of the year. There was an increase of 30% in the number of presenting companies but 20% less audience, a clear sign of the overflow of potential suppliers with a much reduced number of customers (and investors…). It is probable that next year we will see significantly fewer companies present as the money raised in the “2000 hype” starts to dwindle. The percentage of companies that will survive is anybody’s guess; there will be a high rate of closures and hopefully of consolidation -- so that the tremendous R&D progress brought by these startups will not go down the drain. The current market conditions will cause only the best companies with strong management and a clear market value proposition to survive; as a result, today’s market will improve the general quality levels and eliminate the high “noise level” present in the industry.

So why are VCs still investing in this overcrowded space? RHK estimates that although total VC investment has dropped from $134b to slightly over $30b (down 75%), Optical Components companies alone have received over $1.3b in 2001, down from $1.8b in 2000 (only 28% less). The answer lays in the long-term market potential and the relative technology immaturity of optical networks. The optical communication industry is still in its infancy, current networks are still relatively primitive, very static and inflexible and still mostly based on expensive electronic reconversion for everything other than basic signal processing. The goal of an all-optical network is still far ahead, but presents a massive opportunity that startups and VCs are targeting. Furthermore, the total optical communications market has been over $20b in the US alone in 2000 -- and apart from the next two years which will experience a slight correction -- will continue to grow at a very healthy double-digit rate. To prove this, consider that bandwidth demand has grown more than 100% yearly and that the potential growth ahead is strong as broadband penetration is still small but growing at strong rates. (Only 10% of US households have broadband connectivity today).

The Israeli optical communication industry has followed quite closely the industry as a whole. After the big hype of 2000, investments in optics has decreased significantly, but the number of companies in startup or incubation mode is still growing. Apart from the strong market potential, Israel still has the best optical deal flow following the US.
There are currently more than 80 optics-related companies in Israel (and some more in incubation), thanks to the impressive flow of high-quality people that has emerged from top universities, elite military units and from the Russian immigration. On top of this, “the Chromatis effect” has drawn top technologists from other fields, attracted by the potential of the optical industry. This has introduced a productive cross-fertilization of ideas into the already fertile Israeli optical ground.

The Israeli optical landscape is impressive. While system companies have traditionally found it difficult to succeed in the Israeli environment mainly due to the complexity of selling directly into service providers, we are seeing a few examples of companies that can actually make it: Chiaro, Atrica and Native Networks seem to have what it takes to tackle their respective markets, and have raised a significant amount of money to reach their targets. Going down the food chain, companies like CyOptics, Lasercomm, Lynx and Memlink, although hit by the current market situation, have been pointed to as potential winners to watch when the market recovers. It is up to them and the other startups to make sure their money lasts until the market recovers, as financing rounds for non-revenue companies is increasingly difficult these days.

Although last year Morgan Stanley’s prediction of 4-6 Israeli optical companies acquired by big global vendors has not yet materialized, due to the non-existent M&A market, watch out for the end of 2002 and 2003. By then, hopefully the market rebound will allow vendors that have drastically reduced their R&D resources to improve the bottom line, to go fishing for the cutting-edge optical technology available in Israel. Israeli technology acquisition will allow them to provide service providers with the much-needed next generation cost effective systems.

In summary, the Israeli optical industry is passing an extremely challenging period where market, competition and financing conditions are among the worst the industry has ever experienced. Yet, the quality of the teams and technologies in Israel and the long-term market potential still makes Israeli optics an extremely attractive sector to invest in especially at the current reasonable valuations and proposed cost-structure. We will definitely experience a number of shut-downs in the next 18 months, but by the end of 2003, the companies that will have survived, will be able to reap the fruits of a big opportunity.

Astorre Modena, Israel Seed Partners

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