For those of you who think the glory days of fibre optics are over, consider this. Last year China's telcos, which serve a market of over a billion customers, added about 20 million fixed lines and continued construction of backbone and local loop fibre networks at a feverish pace.

And there is much more to come: over the next several years demand for wave division multiplexing equipment in China is expected to grow at triple-digit rates, with more than $7 billion in equipment spending projected by 2004.

Is it possible that fibre optics, the once-golden child of the technology sector, still holds a golden apple?

We at Bain & Company think so. The precious fruit that will sustain the sector: strong underlying demand.

DEMAND IS REAL

Unlike dotcom revenues and profits that proved elusive because customers didn't value all the online goods or services, demand is real for the fibre-optic pipes that run underneath cities connecting the internet to homes and office buildings. Businesses and consumers are demanding increased voice and data capacity at a rate spurring 90% growth (measured in gigabytes per second) a year.

The only way for the telecom companies to provide this increased bandwidth is to build out their system with fibre optics.

There is plenty of building to come. The US is by far the most fibre-enabled country and yet fewer than 5% of the 750,000 multi-tenant commercial buildings and fewer homes have fibre connections to the high-speed data networks, called metro rings, that loop through most metropolitan areas.

In addition, more and more fibre optic metro rings are being threaded under towns. US cities from New York to Omaha to Albuquerque are scheduled for metro ring installations by year-end.

Europe and Asia lag three-to-five years behind the US. While European growth matches the US rate, China is building several times as fast.

If you do the maths—more metro rings, plus cables connecting rings together, plus buildings connected to the rings—demand adds up to about 30% annual growth in sales of fibre optic components.

True, several telcos have announced a dip in their capital expenses for build-out this quarter, but we believe this is only a temporary correction. This 30% annual growth can support fibre optic infrastructure demand reliably for the next three to five years.

Several fibre optic component companies, although retrenching in the short run, are positioning themselves to capture this growth. The industry is maturing and the dynamics are shifting.

Look for winners to differentiate themselves in the following ways:

- dramatic growth in price-performance;

- shift to offshore supply;

- careful customer selection;

- successful merger integration;

- superior design-in capabilities;

- refined strategic focus.

Management of JDS Uniphase has stated they expect to see a year-over-year decline of 15-20% in average selling price.

We expect the rest of the industry to drop prices, too. Optical component purchasers are driving prices down partly on precedent—technology prices always go down over time—and partly because fibre will need to get cheaper to be considered a viable replacement for old copper wires.

Over the past decade, fibre optic advances have resulted in the bandwidth available from a single fibre to rise by over 300 times. The result: steep reduction the price per equivalent unit of telecom capacity by a whopping 80% per generation—typically four years.

Looking ahead it is not certain that technology, alone, will maintain this trend. Good old-fashioned cost control will be needed.

Fibre-optic players have long recognized that much of the demand for their product will be overseas telecom companies.

But what only a few are waking up to is the cost advantage of manufacturing offshore. Surprisingly, most fibre optic component plants are in the high-rent technology districts of San Jose or Boston. Given the labour-intensive manufacturing process, this can get pricey.

To shave cost, more will follow JDSU's lead. JDSU already employs over 3,500 people in China and Taiwan, and just opened it fourth plant in Shenzhen, China, close to Hong Kong. Lucent and Nortel have also aggressively shifted production to China for products ranging from fibre cables to SDH equipment.

CUSTOMER SELECTION

The economics—upside and downside—of customer selection by fibre players has been a major factor in the shakeout in the telecom equipment sector.

If your customers were upstart, competitive, local-exchange carriers that overbuilt, you felt their pain when they retrenched or collapsed.

Indeed, a significant portion of the surge in equipment demand over the past three or four years was caused by an "over-build" in long-distance and local-loop fibre: with capital markets tightening up and several upstarts falling down such over-build is fast vanishing.

Now fibre optics vendors are cherry-picking customers with hard demand, principally former state-run monopolies that need to upgrade their networks.

Component makers supplying the biggest deployers of fibre—the incumbent or former-incumbent monopolies such as the Baby Bells and China Telecom—will survive and prosper. But those dependent on start-up CLECs will find the going difficult.

MERGER INTEGRATION

At least 40 optical components companies have been bought in the last 24 months. However many acquisitions have not been integrated or the integration is struggling.

The challenge: skills needed to merge two organizations differ from those needed to grow a technology company. This makes merger integration a stretch for a number of management teams.

Even a seasoned acquirer such as Cisco Systems has made missteps in its attempts to become a fibre powerhouse, most recently announcing its discontinuation of a core optical router product for which it paid $500 million in its 1999 purchase of Monterey Networks.

Still, integration is necessary to create new companies greater than the sum of merged parts.

Fibre optic systems are incredibly complex, largely customized and often at the leading edge of technology.

WAR FOR TALENT

Senior fibre-optic engineers—the limited number of people who can translate customer needs into designs—are essential to the process. "Talk about a war for talent," quipped one optical component company executive describing this concern.

The company that can retain these people will be rewarded - but expect a good fight from competitors.

Industry leader Nortel is the biggest customer of two of its largest competitors—JSDU and Corning. Yet all three are competing for telecom carrier business.

The current environment forgives companies that compete with their customers, but this won't last for long. As competition stiffens, look for the major players to pick their friends and their foes. And look for the cost of strategic missteps to increase.

For example, Lucent has paid a steep price for trailing in the market for leading-edge optical transmission equipment based on the OC-192 standard.

Fibre optics still holds a promise for equipment makers and services providers that target the right opportunities. But expect to see fallout and consolidation: there will be clear winners, who will distinguish themselves with sound strategies and flawless execution, whilst firms that fall behind strategically or operationally will wither away.