Outsourced Manufacturing Will Have Little Impact on Optical Suppliers' Operating Margins

Courtesy: http://seekingalpha.com/

One of the great debates taking place right now within the optical components industry is whether to outsource production, and move to a fabless model like most logic chip makers. One one side of the argument, Finisar (FNSR) is staying in-house, while rival JDS Uniphase (JDSU) is preparing to send its manufacturing operations to Fabrinet in China.

Advanced Technology vs. Standard Economics

The components industry is littered with penny stocks, and is filled with remarkably intelligent people who can improve the transmission capabilities of fiber optic technologies, but have no idea how to increase operating margins. As a result, all kinds of experiments with different materials and manufacturing processes are taking place now, and the industry is crossing its fingers and hoping something sticks. On one end, silicon photonics vendors like Intel (INTC), Luxtera, and Lightwire are hoping they can match the chip industry's low materials costs, while on the other, JDS Uniphase is hoping it can match the chip industry's low unit manufacturing costs.

The idea to outsource like chip vendors do makes some sense. By concentrating procurement and manufacturing, there should be some savings in material purchases and shipping, not to mention greater leverage with volume purchase arrangements. But outsourcing cannot get rid of onerous VMI (Vendor Managed Inventory) agreements, which force components suppliers to consign inventory at their customer's manufacturing sites, contract or in-house, even when the customer has made no commitment to purchase everything that ships. With inventory cycles that typically last 70-100 days, this forces components vendors to bear most of the risk of unsold and obsolete inventory, and they will need additional mergers to gain more negotiating leverage with big customers like Cisco (CSCO), Alcatel-Lucent (ALU), and Fujitsu.

More important than VMIs though, is the fact that there is no optical equivalent to the dramatically rising lithography and equipment costs seen in the semiconductor industry. With optics, much of the manufacturing cost gets tied up in assembly and testing, which typically means hiring more people, not buying advanced etching machines. This is reflected in the high asset utilization of components vendors. Finisar's Revenue/PP&E of 6 is higher than the 4.6 put up by fabless semi maker Xilinx (XLNX).

Bringing Mundane Inventory Management to Exciting Science

The optical components industry is still having trouble ridding itself of its science fair culture, and this is reflected in the nonsensical argument that outsourcing somehow puts intellectual property at risk. If this were really the case, the entire datacom and semiconductor industries would have been done in by copycats. Nonetheless, it is also poised to resume its revenue growth with the advent of 100 Gigabit transmission, and further advances in DWDM and Fiber-to-the-Home. And with a labor-intensive manufacturing process, outsourcing cannot raise margins to the extent it does in the capital-intensive semiconductor industry. As a result, focusing on the cost effectiveness of what happens before and after manufacturing, including shipping, purchase agreements, and consignment sales, will be just as important as deciding who will be responsible for final assembly.