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Investology

It's not rocket science, a balance between risk and reward

October 31, 1999

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The future of internet investing as we see it today lies largely with companies who will be able to efficiently meet the insatiable appetite for more bandwidth - how much voice, image and data can be gathered or transmitted in how much time.

There is an increasing number of companies who are working hard in this space to meet the need of bandwidth-hungry customers. Often, the terms "backbone" and "last mile" are used when talking about bandwidth. The backbone is the long-distance portion, while the last mile refers to the local portion that goes from the backbone to the customer.

We've seen significant upgrades to the backbone of the network, but in terms of providing increased bandwidth through the last mile, the local area connection has to be upgraded as well. There are several ways of solving the last-mile problem :-

1. Wireless technology, via MMDS (Metropolitan Multiple Distribution Service) and the LMDS (Local Multi-point Distribution Service) band. MMDS & LMDS are different spectrums in the radio frequency band, allocated for two-way transfer of voice, video and data.
2. Telephone, via DSL (digital subscriber line) technology, which basically takes the existing copper infrastructure used for normal phone conversations and upgrades it to a digital network, thereby allowing for a significant increase - hundreds or tens of hundreds times more bandwidth
3. Cable technology, via coax, which essentially uses the cable that brings TV service to transmit data. To provide two-way services, the one-way cable broadcast network has to be upgraded to a two-way interactive network. This upgrade requires the addition of fiber optics and also two-way transmitters into the cable network.

The telephone deregulation act of 1996 is what's driving the competition among providers of those different services. So now pretty much anybody, including the utility companies, is allowed to provide telecommunication services to the customer.

No one method will dominate the market.

DSL - more suited to the business marketplace, since office buildings are not typically wired with coaxial cable.

Cable - has a higher capacity than DSL, allowing for bundled services to be offered -- voice, video and data over one pipe. This will be very compelling to the consumer and we think cable will surface as the dominant means of broadband access to the residential marketplace.

Wireless - will be a great tool for those who don't have access to copper loops or coaxial cable.

There are both reasons for and against cable access as there are with DSL. For the investor interested in equipment stocks the cable side of the equation is at least less cloudy than that for DSL and at best, a stronger market. Of course we will have to wait and see whether one medium becomes a standard at the expense of the other, but at this point cable has far greater market penetration. One of the most exciting things today, is the transition of the cable network into a full-service telecommunications network. That really means a rebuilding of what we have known as the cable-guy type network, where you'd have fuzzy cable and that's all you could expect. Now what's happening is that people are putting much more reliable, telco-quality equipment into that network and really transforming it. The capacity of the coaxial cable is so much greater than that of your telephone wire that you're going to see an explosion of new

service offerings.

When there are too many subscribers in one area, bandwidth slows down considerably because with a cable network, users share the same wire, so as you add more users, each user has to share a certain amount of bandwidth with the group. So Excite@Home (ATHM) in the beginning had some issues in terms of promising a lot of bandwidth and then not being able to deliver. But they've solved those issues in the short term by limiting the amount of bandwidth each person may use. Longer term, AT&T (T) is making aggressive moves to segment its network, thereby providing significantly more bandwidth to smaller groups of people. This is one of the drivers behind the immense growth of companies such as ANTEC (ANTC), Harmonic (HLIT) and JDS Uniphase (JDSU).

Projections by Forrester Research, Forward Concepts and Strategis Group appear to show that cable (cable modem) will win the war against other media. The leaders in this field are Motorola (45% market share but has problems on the satellite side of the business), Nortel Networks (30% market share), Terayon (10%) and Com 21 (10% - has product certification issues to resolve)

One interesting way to play this market is to invest in companies that develop the core DSL technology - Aware (AWRE), Alcatel, Orckit Communications (ORCT), Pair Gain (PAIR) and Amati/Texas Instruments (TI). Among this group, Aware's licensed DSL-enabled chipsets, modems, PCs, access routers and transceivers are built into more than half of all DSL equipment used. They are appealing since they allow phone companies to upgrade existing transmission lines without replacing wire, while enabling end users to access the web faster.

AWRE's strategy has been to license its technology to the semiconductor manufacturers who build it into the DSL-ready integrated circuits used by equipment manufacturers. At present, just about every regional bell operating company and major ISP is installing DSL capability.

Unfortunately, AWRE's stock price hasn't reflected its revenue growth or the rapid acceptance of its technology. While Q1 '99 sales grew 115% to $4.3 million, of which licensing fees amounted to more than $700,000, it has retreated to its December '98 price of $25, after hitting a high of $87 in April.

Since August, in fact, when AWRE hit an interim peak of $60, it has been on a steady decline. Orckit, on the other hand, has been on an uptrend since August. Its revenues have also been rising dramatically - 76% to $30.7 million for the first half of this year - along with its stock price. Since August, ORCT has moved from $25 to $37, as 3 analysts (Kaufman Bros, Josephthal Lyon, Merrill Lynch) initiated coverage.

DSL is a new technology that is only now starting to be considered viable and not all of the companies developing it offer good investment opportunities.

It's pretty much a steady state in terms of the equipment vendors. There are always the phenomena where the bigger fish will buy the small fish with excellent products, and We think you're going to see that on an ongoing basis. We don't feel that there is any particular merger frenzy happening right now in the equipment space. In the cable services space, most of the consolidation has taken place and We don't think they'll see a lot more there.

In the short term, there will be a delay in the more aggressive strategic initiatives that both of these companies have been planning. For example, Sprint's (FON) ION network which was intended to start rolling out in Q1 2000, will most probably be delayed at least one quarter.

Longer term, spending patterns should come back to normal levels. For companies in the infrastructure space that currently derive a large portion of revenue from the two companies, such as CIENA (CIEN), this could mean lower-than-expected revenues in the near term.

Overall, however, infrastructure spending is so strong across the board that the Sprint/MCI chaos will have minimal, if any, effect on the space.

Each stock has specific story. But what we like to look at is a company that has best-of-breed technology. You find that by talking to a lot of customers, figuring out what kind of solutions they're looking for, and then looking for companies that offer those solutions. Also, management is very important. In order to have sustained success, you need to have a management team that's able to handle growth and have a technological vision of where the company's going.

And going forward they've got some OEM relationships with the big optical transport vendors like Lucent (LU), which should give them added benefits longer term. This year, they're going to lose some money and then next year We've got them earning 33 cents. The stock is trading at about $7.50 with accelerating growth. Very strong story there. It's quite attractive.

are excited about. But their business is growing 25% to 30% and they have accelerating earnings growth.