Optical Fiber Corp Case Analysis
Case Analysis: Optical Fiber Corporation Introduction Optical Fiber Corporation (OFC) is a financially successful, albeit relatively small manufacturer of multimode optical fibers. The company was founded in 1990. The founders were able to enter the market largely on the basis of acquiring patent licenses from larger optical fiber firms.
These licenses restricted competition between the entities and provided OFC with instant access to optical fiber technology. In return, OFC’s customer base is limited by the license agreements and royalties of 7% on sales of licensed products (recently renegotiated to 9%) are paid to the licensors.
Despite these handicaps the firm has grown in size and profitability. OFC makes several types of multimode optical fiber including specialty niche products they have developed outside of any license agreements. All customers are cable manufacturers that convert the fibers to optical fiber cable. Three such firms account for over 70% of OFC’s revenues. Focusing on customer service, quality and product design and process improvements has proved a winning business model to date. OFC now faces a variety of challenges including the expiration of many of the patents that afford most of its profits.
This raises the real possibility of new competitors in the market. Further, while in the past multimode and single mode optical fibers have generally been used for data communications and telecommunications respectively and as such were not in direct competition with each other, the advent of cheaper manufacturing processes for single mode fibers coupled with their inherent ability to transmit data more efficiently over longer distances may make them a more appealing choice for some of the uses that historically have favored multimode fibers.
OFC is at now at a crossroads where they must decide if they are to stay in the multimode fiber business only, begin producing single mode fibers as well, or even enter the cabling business with a forward integration strategy. Competition in the Optical Fiber Industry The optical fiber industry is perhaps best considered as two industries that are closely related, the multimode fiber and the single mode fiber industries. The multimode industry in which OFC specializes is very competitive. The United States’ 2001 total optical fiber market was approximately 3. 5 million kilometers only 330 thousand of which was multimode.
The value of the multimode market was $65 million that year, only a fifth that of the single mode market. Within the multimode market and a number of fiber manufacturers. The main rivals for OFC are the two licensors to whom they pay royalties. These firms are considerably larger and have greater resources with which to compete. Further, they have a competitive advantage in that they are the recipients of royalty payments rather than the firm making those payments. Also they are in a position to control the extent of OFC’s market penetration at least with respect to their licensed products.
OFC has responded by creating high quality products and providing exceptional customer service. In addition, OFC has made improvements to the basic design of some of the licensed fibers making them, in a real sense new products. The R and D department at OFC has also been successful at developing new and less expensive manufacturing processes, which has helped to offset the added overhead of the royalty payments. Finally, OFC has developed specialty fibers with medical, aircraft, aerospace and extreme environment applications.
These new fibers will not be subject to royalty payments, competition from new entrants until patents expire years in the future, and generally afford higher profit margins than other optical fiber products. New entrants to the market are a threat to OFC and all other fiber producers. New firms must contend with the high capitalization costs of this technologically demanding and exacting industry. One of the costs of optical fiber production is the R and D required to bring successful products to market. Between 1999 and 2007 the patents for many of the basic fibers produced by OFC and its licensors will expire.
New firms entering the market will be free to produce the products once protected under those patents without having incurred any R and D costs. These firms will also be free from royalty payments to licensors or any restrictive covenants such as those under which OFC operates. The industry in general, and OFC in particular, must contend with the purchasing power of its buyers. Optical fiber is converted into optical fiber cable. In the United States there are twenty companies that perform this function. OFC sells over 70% of their fiber to just three.
The loss of any of these accounts could be devastating for OFC and places them in a weak position when negotiating prices, at least when the products are those which are readily available from other multimode fiber producers. It is doubtful that switching costs would be high for buyers. Favoring OFC and the optical fiber market are the projections for increased demand for multimode optical fibers at least through the mid 2000’s. Sources of increased demand for multimode fiber are anticipated to include: cable TV, undersea cables, local area networks (LAN) as well as general data communications growth such as computer uses.
As noted the single mode optical fiber market is much larger than the multimode market. It too, is expected to see significant growth over the next several years. Single mode fibers have the advantage of efficiently transmitting data over long distances, faster transmission rates and other desirable optical properties but until recently have been more expensive to produce. The advent of cheaper production methods will allow single mode fibers to enter markets that were once dominated by multimode fibers.
Production of these fibers requires expensive specialized manufacturing equipment and a significant commitment to R and D. The industry includes one of the OFC licensors. Substitute products for single mode fibers include microwaves, and satellites for telecommunications. Impact seems limited. Copper wire can be used as a substitute for the fiber-to-home and fiber-to-curb applications of either multimode or single mode fibers but by the mid 2000’s the lowered cost of production of single mode fibers will likely make this the preferred choice for these functions.
Finally, it should be noted that suppliers are unlikely to exert competitive forces on the fiber optics markets. The materials used in the production of fibers are commodities of low value such as glass, certain gases and oxide particles. OFC Strengths OFC has many strengths. The firm is financially strong with record sales and earnings for the last year as well as increased manufacturing capacity. Furthermore, there was a $20 million backlog for optical fibers in the last year and orders are increasing. There was net income of $6. 1million on revenue of $48. million in 2002. The Quick Ratio, a measure of a firm’s ability to meet short-term debt obligations (Current Assets – Inventories)/Current Liabilities = ($31. 0m – $6. 6m)/$12. 5 = 2. 0 is very solid. Return on equity (Net Income/Equity) = $6. 1m/$44. 0m = 13. 9% is also very impressive. OFC has developed new specialty products for medical, military, commercial aircraft, aerospace and severe environment uses. These are likely to receive patents and will not require royalty payments and will be protected from competitors for years to come.
The firm has a variety of options to confront the challenges of the changing market place. OFC has patent licenses to produce optical cables that would allow for forward integration if they chose to move in that direction. Engineers at OFC have been able to find new ways to produce old products more efficiently reducing production costs. They have also developed adaptations of existing products to create new and unique demands for those products. OFC is in an industry that is expected to enjoy strong growth for at least the next several years.
That demand will come from a variety of industries adding stability to the market. The equipment needed to produce optical fiber is expensive and the expertise demanding creating, a relative barrier to entry. Copper wire as a substitute is relatively expensive and as technological advances decrease the cost of optical fibers copper will become a non-entity. Perhaps most importantly, OFC has a strong reputation for quality, service and competitive pricing. OFC Weaknesses OFC is a small company. They were only able to enter the market by virtue of other firms’ products and license agreements.
Those licenses have protected OFC from competition but have also limited the scope of its customer base and added significant fixed costs in royalty payments. Royalties will now increase to 9% (after paying a one time $3 million fee) on 85% of sales. Furthermore, while OFC is paying royalties to use these patents new entrants may soon be competing as patents expire. These firms will have essentially no R and D expense and of course no royalty payments potentially allowing them to produce at costs below those of OFC.
OFC must also contend with a limited number of buyers. Over 70% of sales are to just three cable producers. The ability of OFC to increase prices to these large purchasers is doubtful. If even one of these customers were lost to an alternative fiber optic producer the effect on OFC could be dramatic. OFC operates in a competitive industry that will become more so with time. Copper wire manufacturers will turn to optical cable production to stay relevant. Overseas producers, already sources of competition to OFC, are likely to play a larger role in the future.
Finally, OFC’s success has been built on quality, service and innovation. One or more competitor can potentially offer all of these. OFC’s Core Competencies OFC manufactures multimode, high quality optical fiber for cabling companies that convert that fiber into cable for a variety of data communications uses. The firm has a reputation for low prices and excellent customer service. Much of their success can be attributed to their R and D program, which has developed cost saving production technologies as well as product innovations.
More recently, OFC has shown itself to be an innovator, developing entirely new multimode optical fiber products that fill a variety of unique niche functions. To continue producing and selling multimode optical fiber successfully, OFC needs to prepare for increased competition as patent protections expire. As new entrants begin producing many of the higher volume OFC products, likely at lower cost given their lack of R and D and royalty expenses, OFC will need to spend additional resources on developing decreased costs of production if they are to continue selling those products profitably.
They will need to maintain their focus on quality and customer service. In part that will require continued product testing. They may wish to explore, however, if testing 100% of products as is current policy is necessary or if testing samples from each batch would serve as well and save money. OFC will need to continue to support R and D to develop new products and patentable improvements on existing ones. Options Available for Growth Pursuit of Niche Markets OFC has already demonstrated an ability to develop marketable niche multimode fibers. Previously created are fibers able to withstand high radiation nvironments for nuclear reactor and military applications, a fiber that can tolerate deep underwater submersion and a third tolerant of high heat conditions. They have also successfully experimented with a fiber capable of transmitting UV light and another with unique medical and scientific uses. To continue their development program for specialty fibers will require annual R and D spending increases of $400,000 and an additional annual expenditure for three new staff totaling $325,000. Outside firms can be hired to handle sales for 10% commissions.
When sales volumes are adequate, salaried OFC employees can be used instead. The calculation as to when this makes financial sense for the firm is simple; when 10% of sales exceed the salary and benefit expenses of the needed in-house sales force then sales should become an OFC operation. The advantage of niche products is the lack of competition and relatively higher margins. Develop Single Mode Fiber Capacity OFC could choose to enter the much larger single mode fiber market. It is estimated that this will require a capital investment of $4 million for new plant and equipment.
It will take a year for the new facilities to be operational. There will also be a reported one time R and D expense of $2. 5 million. This is a first year expense so it cannot be capitalized. It can reasonably be assumed that there will be additional R and D expenses going forward although presumably these would be considerably lower than the initial expense. Entering the single mode market places OFC in competition with larger firms than it currently faces with greater resources to sell products with thinner margins and would divert OFC resources from their core business functions.
Forward Integration A third option for OFC is to produce optical cable. The required patent licenses are available. Two options for this forward integration strategy exist. OFC can commit $5 million in capital investments and plan on spending an additional $500,000 annually for R and D or they can simply purchase a cabling company for an estimated $10 – 15 million in capital expenditure. There is currently an excess supply of cable and cabling firms and several are in danger of bankruptcy and so an acquisition should be feasible. Forward integration raises several concerns.
Regardless of the approach taken, entering the fiber optic cable business will be expensive for OFC. This is a market that is already experiencing an excess of capacity so it can be assumed that at least for some time to come profits in the cabling industry will be squeezed. This is not a core business function of OFC but to pursue cable production will be so expensive as to necessarily draw resources away from some of the firm’s core activities, activities that are likely to be more profitable and entail less financial risk. Finally, one needs to consider that all of OFC’s customers are cable producers.
If OFC enters this market they will become a competitor of their customers. It seems highly probable that at least some of these optical fiber buyers will respond in a retaliatory manner and switch to alternate suppliers. Most of OFC’s products are not unique and can be supplied by their licensors. The three large buyers would seem in a particularly strong position to adversely respond to any entry into the cabling market by OFC. OFC Policy Statement In choosing a direction for the future growth of OFC several considerations should be kept in mind. First, OFC has been successful in large part because of its focus on quality.
Any efforts at growth should not come at the expense of producing high quality products. Second, the firm must continue to provide a high level of customer service. This should include responsiveness to customers’ needs for new products and product features when those offerings are commensurate with the firm’s vision, available or attainable expertise and when economically viable. Finally, the firm should continue to fund R and D efforts to allow for a continuous pipeline of new products and improvements to existing ones in an effort to maintain a unique competitive position in the market.
OFC has been successful in competing against larger firms by avoiding head to head competition. Initially this was accomplished through license agreements alone. Later, the firm was able to create unique improvements to existing products and processes that gave it an advantage. Most recently OFC has created unique patentable products. These represent three different ways of avoiding direct competition. Despite their growth, OFC remains a relatively small firm in the optical fiber space and should continue to eschew direct competition when possible, realizing that the market is dominated by larger and better-funded firms.
Recommendations OFC should stay out of the cable producing business. This market is the least profitable, most expensive to enter and likely to have the lowest return on investment. It is also likely to result in retaliation by current customers and reduced sales. The single mode market is much larger than the multimode market but as a consequence will bring OFC in contact with larger firms that already have the equipment and knowledge base to produce these products. A small firm with limited resources should not leave its core competencies behind to take on firms that are already in place.
OFC needs to continue to make niche products whether they are improvements on old multimode fibers or new fibers with unique properties and functions. This firm will never be a big player in the highly competitive optical fiber industry, they arrived too late and don’t have the capital to displace the dominant firms. Given that projections are for most of the increased demand for optical fibers to occur through the mid to late 2000’s OFC may want to watch for an opportune time to sell to one of these larger entities, perhaps a single mode fiber producer to whom the OFC product line would prove complimentary.