Charge Of The Light Brigade

Next-generation optical gear is entering the local market

Two years ago, Hugh Martin was enjoying the Silicon Valley version of a sabbatical. The veteran of Apple Computer and struggling computer-game maker 3DO was an "executive in residence" at the venture capital powerhouse Kleiner Perkins Caufield & Byers. Then in late 1997, Kleiner partners offered him a chief executive post at any of the dozen startups in their portfolio. He chose Optical Networks Inc. (ONI), which makes communications equipment that carries voice and data traffic on glass fibers instead of the traditional copper wires. "I was knocked out by the business plan," says Martin.

Good choice. Over the past year, optical-networking companies have become the darlings of the technology world. Just check out Sycamore Networks Inc. Its stock has rocketed sevenfold since its initial public offering in October, for a market cap of $21 billion--even though it has a minuscule $19 million in revenues. Contender Qtera Corp., with almost no revenues, got scooped up by telecom-equipment giant Nortel Networks Corp. last month for $3.25 billion. And on Jan. 17, equipment maker JDS Uniphase Corp. agreed to acquire an optical-networking player called E-Tek Dynamics Inc. for $15 billion.

Now, Martin and ONI may surpass all their brethren. The company makes optical equipment that routes calls within the local-telephone network at a fraction of the cost of competitors' gear. For example, ONI says its optical routers cost $50,000 to $100,000, or half the price of equipment from larger rivals Nortel Networks and Lucent Technologies. Customers are taking note. On Jan. 22, ONI plans to announce that it has landed four deals that will generate $50 million in revenues over the next two years, including a $30 million order from European upstart COLT Telecommunications. Based on comparisons to companies like Sycamore Networks, ONI already could be worth $20 billion, according to Robertson Stephens analyst Paul Johnson.

Why is optical networking all the rage on Wall Street? The technology could be crucial in realizing the promise of the Internet. Right now, the rickety old telephone networks are straining as the flood of Net traffic in the country doubles every month. Optical technology has the potential to boost the capacity of telephone companies' networks a millionfold. "You're not going to be a player in the next generation without optics," says Michael O'Dell, chief scientist at MCI WorldCom Inc.'s UUNet Internet unit. "It's life and death."

COLORED BANDS. Here's an inside peek into how optical technology works: Traditional phone networks turn voice or data into electrical impulses called electrons that travel on copper wires. Optical networks convert that information into bits of light--photons--that are sent over fiber-optic cables made of glass. Optical networks have a million times the capacity of traditional phone systems because photons are lighter than electrons and can travel faster because they encounter less resistance in glass.

And optical technology is improving dramatically. In 1995, equipment makers discovered that special lasers could shoot multiple bands of light through a single strand of fiber-optic cable. The bands of light are each a different color, although they aren't visible to the human eye. These first systems split a fiber into eight separate colors, each carrying 120,000 calls. The latest systems, known as dense wave division multiplexing, break a fiber into 128 colors, and Lucent has tested systems that produce 1,022. In other words, a single optic fiber that used to carry 120,000 calls can now carry a staggering 12 million--and that will grow to more than 100 million in the next few years.

While advanced optical equipment already has been rolled out in the long-distance market, it's just starting to take hold in the local phone markets. Optical equipment hasn't been cost-effective in neighborhoods until now because local carriers can't spread fixed costs among as many customers as long-distance carriers. But costs are dropping, and demand for more capacity is rising thanks to the Net. So regional Bells and GTE Corp. are ready to retool. "Everyone will start using [optical technology] in the local market," says Ray Albers, director of network architecture at Bell Atlantic Corp., which is rolling out its first DWDM network in New York City. And not just phone companies. Even corporations are beginning to buy optical equipment to increase the speed of the connections among their office buildings. Overall, the local market for optical equipment will hit $5 billion or more in 2003, up from $100 million in 1999, analysts estimate.

Local-phone companies need to spend billions to meet the growing needs of America's Web surfers. Households and businesses are upgrading to high-speed phone lines that spew vast amounts of data, often 20 times the amount of data they've sent in the past. The number of speedy access methods--cable modems and high-speed digital subscriber lines (DSLs)--will double this year in the U.S., to about 3 million, Yankee Group Research Inc. says. Those lines that come out of people's homes are like side streets that feed into main avenues. As the side streets become busier with DSL traffic and the like, optical technology will be used to widen the avenues.

TEAM PLAYERS. The battle for the local-phone market is so fierce that a legal battle erupted between ONI and Nortel. ONI's equipment is based on technology created by Rohit Sharma, who worked at a firm partly owned by Nortel. When Martin arrived as CEO, he hired so many of Sharma's acquaintances at Nortel that he was able to field a company hockey team in Silicon Valley. Nortel was furious and filed a lawsuit. A court decision handed down last year ruled that ONI could hire Nortel employees as long as they don't contribute specific Nortel ideas to the upstart.

Nortel has reason to be sensitive. The former Northern Telecom has been the leading equipment vendor to local phone companies, in part because the regional Bells and GTE were reluctant to buy from Lucent, which was part of AT&T until four years ago.

Now, ONI is offering a tough challenge to both giants. Martin brings the economics of the computer industry into the optical-equipment market. While traditional phone gear uses massive central power systems and computer processors, ONI's products incorporate smaller equipment that can be scaled up incrementally to meet the needs of customers. That scalability is critical in the local market because one piece of equipment often serves a smaller population than in the long-distance market. For example, Nortel and Lucent sell gear with backup power supplies that cost about $2,000, while ONI uses tiny power systems that start at $100 and can be added to incrementally. "They are going to be a hot company," says analyst James Kedersha of S.G. Cowen Securities Corp. Networking rivals Cisco Systems and Juniper Networks both have invested in the company.

BIG DISCOUNTS. Not that Nortel and Lucent are conceding an inch. Both acknowledge that ONI may have some cost advantages in its optical equipment. But they argue that they have long relationships with the phone companies--and they'll offer big discounts if their customers buy packages of products. Nortel, for one, expects to thrive against ONI. "The numbers that we achieved in 1999 give us comfort that we are going to take off in 2000," says Don Smith, vice-president and general manager of Nortel's Optera metro equipment unit.

As for Lucent, it conceded that revenue and profit growth in the fourth quarter of 1999 won't meet analysts' expectations in part because it underestimated demand for optical equipment. After his stock tumbled 23% in one day, Lucent Chairman Richard A. McGinn insists the company won't make that mistake again. "We expect the metro market to be very significant," McGinn says.

Martin expects to hold his own against the giants. "We are going to give the incumbents a run for their money because our equipment is designed from the ground up for this market," he says. If he's right, Martin may have made the best career choice of his life.

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