InSite Partners Company Logo, Principals Jo Major and Marla Sanchez
Home Activities Media News About

Industry Analytics

InSite Newsletter, June 2009

"Whatever you do, or dream you can, begin it.
Action has genius and power and magic in it."
Johann Wolfgang von Goethe (1749-1832)

This newsletter is dedicated to the people who have made careers in the telecom optics sector. It is an extraordinary industry, with fascinating and elegant technology, but with complex business challenges and no convenient or easy fixes.

A set of generalized tools for looking at any public company sector is discussed. These tools are designed to collect, analyze and present data in a way that is useful for evaluating corporate or sector performance.

The newsletter tracks the performance of the optical telecom component sector over a 12-year period, 1997-2008, divided into several time-periods for analysis. In each time-period, appropriate strategies are discussed with metrics to measure executive performance. It should be noted that such an analytic approach is only one component of effective decision-making.

Approach

We studied the following companies: JDSU, incorporating Acterna (Dynatech), Uniphase, E-Tek Dynamics, SDLI; Finisar, including Optium; Oclaro, consisting of Bookham, New Focus, and Avanex; Oplink, including OCPI; and Opnext; for a 12-year period spanning 1997-2008.

To do this, we constructed a software system that can extract every 10Q and 10K filed for each of the companies, consisting of nearly 400 public documents. The program then produces standardized financial statements:† Income Statement, Balance Sheet, and Statement of Cash Flows. This is a critical part of our process because the information content of financial documents from public companies varies quite dramatically, and comparisons require that the same items be compared to each other, relatively. We start the analysis by simply adding the standardized financial statements of these companies together, calling them the "Group".† This provides a picture of the overall health of the industry.

All figures are based upon Generally Accepted Accounting Practices (GAAP) numbers, with no pro-forma results considered. We use GAAP numbers for several reasons.† First, it is the only consistent comparison available. Non-GAAP measures are subjective and inconsistent from company to company. Further, even within an analysis of a single company, the definition of non-GAAP measurements can change over time. Second, non-GAAP numbers are misleading in a discussion of this industry, due to its pattern of acquisitions, mergers, and restructurings. Over this 12-year period, the dollar value of items excluded from non-GAAP financials is more than twice the integrated revenue of the industry. Finally, we firmly believe that the best bet to improve the future of the industry is to objectively look at the full performance of the industry, not by focusing discussion upon non-GAAP figures of relative merit, such as, pro-forma EBITDA.

Discussion

The telecom bubble led to a dramatic increase of revenue for the Group in the late 90ís, followed by a breath-taking decrease in revenue throughout 2001-2003. Following the industryís collapse, the industry recovered partially, with a 4x increase in revenue that eventually exceeded $800M, prior to slowing in the latter part of 2007 and throughout 2008.

Telecom Group Revenue 1997-2008

The gross margin performance of the industry is considered next. At a very high level, the average gross margin was >50% until the ramp period, at which point it began a gentle decline. Following the bursting of the bubble, the industry saw gross margin plummet and then gradually rise to 30-35% in the 2007-2008 timeframe.

Telecom Group Gross Margins 1997-2008

Prior to and including 1997, the industry had moderate revenue growth, gross margins in the 50% range and profitability, after taxes, of slightly below 10%. During the ramp period of 1998-2000, however, two disturbing trends appeared. First, despite the extraordinary demand, gross margins began slipping. Second, the industry began to lose increasing amounts of money, primarily as acquisitions began to underperform expectations and were written down. As the bubble burst, the losses of the industry grew rapidly, as the acquisitions were written down and the infrastructure of the Group was reduced in scope. If we define the period of industry collapse as 2001-2003, the industry had losses of ~$65B on revenues slightly under $3B. The industry began an uneven recovery from 2004-2006. Finally, in 2008, the Group saw losses increase when the recession began, losing $0.7B on $3.0B of sales.

Telecom Group Losses 1997-2008

Metrics

At this point, we examine a larger suite of key metrics from both the Income Statement and the Balance Sheet. In general, most management teams are driven by Income Statement metrics, with revenue receiving the spotlight of attention. In many situations, the real issues with a company or sector are much easier to detect by focusing on Balance Sheet metrics or metrics that mix combine Income Statement and Balance Sheet line items. Letís start by just looking at the raw data for the Group in Fig. 4.

Staring at Fig. 4, you might have the reaction that these are numbers swimming on a page, and you might have a little trouble focusing without the little lines wiggling. OrÖ. you may be a really nerdy sort of person and have trouble extricating yourself from deciphering what all these fascinating numbers mean. Either way, it would likely take considerable effort to come to even a rudimentary understanding of which metrics were appropriate for management focus.

Table of Telecom Group Metrics

If you seek to verify this, simply print out Fig. 4 and hand it to any business group, be it the folks in a private equity firm, a venture capital shop, an investment banking team, or the board of a company. Ask them, for a specific year, "What set of metrics are most appropriate to use as measurements of the long-term effectiveness of a management team?" The discussion will be broad in scope, covering all sort of different topics, highly qualitative, likely emotional, and often leading to frustration due to data overload, and the lack of common understanding.

The reality of the business world is that we are all surrounded by readily available data, and the true challenge of a thoughtful manager is to collect this information quickly, and have this information structured in a way that lends itself to very rapidly reaching reasonable decisions for moving the business forward.

To make this exercise more manageable, we structured the data into a format that provides meaningful and quick interpretation of the data. This work begins by noting that the industry had relatively healthy 50% gross margins and nearly 10% ROS prior to the telecom growth frenzy. In addition, we use comparisons to other healthy tech industries to further develop a set of benchmarks. These are used to develop criteria for each metric.† The data is then color-coded:† green for healthy, orange for caution, and red for danger. Further explanations are provided for each metric, with a second set of color-coding helping the reader understand the origin of the data.

With Fig. 5, the task of picking the right metrics for management focus becomes much easier; with clear areas of weakness made obvious by this simple color-coding. Focus areas are almost by definition areas of orange or red.

Telecom Group Performance Chart

Strengths

If we start with the strengths of the industry, the most obvious is the general liquidity and working capital strength. The industry easily passes liquidity tests, has little debt, and has very high working capital.

In general, revenue growth has been acceptable for the industry. While the peak revenues of the industry havenít been repeated, it is clear that the optical telecommunication industry does have a strong and growing place in the economy.†

Challenges

The obvious performance challenge in this industry is that all metrics associated with profitability have been poor. From the second quarter of 1999 to the end of 2008, the Group has had one profitable quarter, and that quarter had return on sales of 0.7%.† Sixteen quarters, or one out of every three quarters show return on sales (ROS) worse than -50%.

For the Group retained earnings, which is a proxy for cumulative profit/loss, is approximately negative $72 billion dollars. For comparison, over the same time-period of study, the total revenue of the Group studied is only $23 billion dollars. Most of the cumulative losses are attributed to write-downs of acquisitions and restructuring charges for the acquisitions. The data studied suggests that Group performance has not been improved through these consolidations, and that the premiums paid for companies have not been recovered.

Asset Discussion

In the analysis of various sectors, the quality of the assets on the balance sheet is interesting. In particular, we examine intangible assets as compared to total assets. In general, significant intangible assets occur when the company purchases an asset for more than current fair market value. More specifically, the purchase of a company typically involves a premium, and that premium appears on the balance sheet as goodwill or other intangible assets after the closing of the deal. In a situation where acquisitions are occurring rapidly at high valuations/premiums, it becomes very difficult for companies to build their tangible asset base as quickly as their intangible assets are growing. Consider a company with $100M of assets buying another company with $100M of assets, both with equal market values. In our first example, the market value of both companies is 1x assets. Company A acquires Company B for a premium of 20%. The change in asset structure is shown below.

Now, letís consider the same two companies in a highly valued environment, where both companies are valued at 25x assets. Again, Company A acquires Company B for a premium of 20%. The change in asset structure is shown below.

It is useful to state that having a high value for intangible/total assets generally means that the company has been the buyer of assets where the premium for the asset is substantially higher that the real assets of the company. It also places extraordinary economic return requirements on the purchased asset to avoid future write-downs and loss.

Equation 1:    P = (P/E) * E = (P/A) * (A/E) * E

Where P is the asset price, E is annual earnings, and A is assets. Re-arranging this gives

Equation 2:    P/A = P/E * E/A = Price to Earnings Ratio * Return on Assets

A P/E ratio of 20 is realistic if the company is seen as having good prospects for growth. An investor expects a minimum annual ROA of 120% from a company with a P/E of 20 and a price to assets of 25.

As the industry began its rapid ramp, intangible assets as a percentage of total assets rose very quickly, eventually reaching 80% of asset value. This occurred well prior to the industry peaking. By comparison, companies with long track records of successful acquisitions typically have goodwill and other intangibles of less than 40% of total asset values.

High valuations and premiums are based upon aggressive predictions of future financials. When the deals are done, all is well: the board, the management, and the auditors are all in perfect harmony. This harmony persists as long as the business forecasts remains roughly in line with the original forecasts. However, if the internal forecast softens, the acquired asset loses implied value, and the intangible portion must be reduced in value. It should be noted that the forecast that forces revaluation is an internal forecast that is periodically evaluated by management and their auditors. Stated differently, if a company writes down an intangible asset, this means that long-range internal business forecasts have substantially weakened.† In summary:

  • Growth in the ratio of intangible assets to total assets suggests that companies are being purchased with premiums comparable to, or larger than, the tangible assets of the company.
  • Purchase valuations are supported by internal forecasts of future performance. In markets with very high valuations, these forecasts are, by definition, very aggressive.
  • Write-downs of intangible assets typically indicate that internal management forecasts have been revised downward.
  • Companies that have long track records of stock appreciation through acquisition generally have intangible assets that are less than 40% of total assets.

Performance Evaluation

We now turn to appropriate metrics for judging the performance of management teams. These comments are intended for a business that wishes to continue as a healthy, independent company.

In this period the market was rising rapidly. The declining gross margin and rapidly worsening profitability is very troubling given the >100%/annum revenue growth. Certainly focus on expansion of gross profit and expansion of net profits would have been appropriate.

From the viewpoint of driving long-term shareholder value, it was recognized at the time that these assets were substantially overvalued by any traditional metric.† While the conventional wisdom was to buy and sell these overpriced assets within the Group, a significantly better strategy would have been to use the high valuations to buy business assets outside of the highly valued Group, as AOL did when it merged with Time-Warner. That deal is often criticized, since from the perspective of an AOL shareholder, they have retained only 24% of their peak share price. However, it is useful to recognize that in a highly speculative "bubble" market, valuations can be very much overstated. If the telecom market leader JDSU had utilized this strategy of partially locking in value, a share of JDSU would now be worth $214, as opposed to the approximately $6 current price.

With a share price of $25 in 1997, JDSU has produced an average return of -12% annually for this 12-year period. Had JDSU adopted the strategy of AOL, and captured a fraction of the peak value of the company, the stock value of $214 would have provided a shareholder an average 20% return over that period.

In a period of collapse, it is critical to get the structure of the companies simplified and the high fixed costs of the business corrected as quickly as possible. Focus on speed, on reducing fixed costs, and on margin expansion are very critical. Placing focus upon revenue in a market with inelastic demand encourages the artificial expansion of market share through price reductions, a very inappropriate behavior. Suggested metrics would target gross margin increases, operating expense reductions, and minimizing cash burn.

In this period revenue growth is acceptable, but the margin and profitability of the industry are far from acceptable. Profitability metrics, including gross profit expansion and operational expense reductions, should be metrics of focus. Again, the primary weakness of the industry is gross margin and profitability, not revenue.

Conclusion

A collection of key optical telecom component companies is studied as a Group.

  • The Group is well funded from a capital perspective.
  • The Group has shown reasonably strong revenue growth.
  • The overall profitability of the Group is poor, in good times and bad.
    • In a period of intense demand (1998-2000), prior to any industry slowdown, the Group lost ~$3.4B on ~$7B of revenue.
    • Cumulative losses are roughly three times the cumulative revenue of the industry.
    • Profitability has worsened from 2006 to 2008, despite increasing revenue. In 2008, the Group lost ~$1B on $3B of revenue.
  • Although the industry has extensively restructured, post-bubble gross margins have never reached 35%.
  • Operational expenses are too high for the gross margin performance of the Group.
    • Research and Development is at 13% for the Group in 2008.
    • MSG&A is 24% in 2008.
    • Operational expenses not captured in R&D or MSG&A are significant for the Group. In more than 25% of the quarters studied, "Other operational expenses" were larger than R&D and MSG&A combined.

For ongoing updates to this industry analysis, individual company comparisons to the Group or for details on the further sector analytic capabilities of InSite, please contact us directly.

Cheers,

The InSite Team

This document contains thoughts and opinions concerning alternative business practices. The recommendations contained within this document may not be appropriate for every business, and InSite Partners, LLC is not responsible for any detrimental effects or results from the use of these ideas and suggestions.

Privacy Statement: InSite Partners does not under any circumstances distribute e-mail addresses of companies or individuals that have contacted us to any third party.  Please be assured that your privacy is one of our primary concerns.