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Based in Fremont, California, Avanex Corporation (AVNX) is a leading provider of optical communication solutions. Avanex Corporation was incorporated in October 1997. The company designs, manufactures and markets fiber optic-based products, known as photonic processors, which increase the performance of optical networks. The company is a global provider of high-performance photonic products which include optical components, modules, and subsystems. These products enable optical communication networks to regenerate, transmit and manage voice, video and data optical signals efficiently. AVNX sells its products to telecommunications system integrators and their network carrier customers, as well as to optical module manufacturers through direct sales, distributors, and representatives in Americas, Europe, and the Asia Pacific. The company acquired the optical components units of Alcatel and Corning in July 2003, and optical assets of Vitesse's Optical Systems Division in August 2003. In March 2007, the company divested 90% of its interest in its France subsidiary.

We are initiating coverage of Avanex Corp. with a Hold rating for long-term, risk-oriented investors with prior exposure to the speculative nature of the stocks in the communication equipment and component space. Based on our belief that (a) the sector has successfully endured a protracted period of consolidation following the boom-bust cycle of the telecommunication industry as a whole, and (b) that the few remaining players have reached the point of inflection, we expect Avanex to demonstrate meaningful result of its own in the quarters ahead. We think that Avanex has finally turned the corner and is now at a stage where the recent restructuring, integration of its earlier acquisitions and the outsourcing of the bulk of its manufacturing capacity should begin to pay off. The company is one of the few remaining pure plays in the optical component space. We expect it to reap the rewards of the growing use of optics related to higher bandwidth demand both at home and in the enterprise. Given Avanex's unique technological edge in providing low-cost, high-efficiency photonic modules for the next generation optical system manufacturers, we believe the company's long-term growth prospect is robust. However, we also pause to indicate that the component industry still remains quite challenging and pricing pressures still persist. Our caution is mainly with respect to the consolidation in the optical component industry overall and the execution risks associated with implementing Avanex's strategy.

Avanex has demonstrated rapid growth since its IPO in 2000 and has continued to develop products that address key challenges for next generation optical networks. The company is primarily a supplier of advanced photonic modules to optical system manufacturers and optical network service providers. We think Avanex remains on track with the proper mix of subsystem development and introduction of new products while at the same time managing and developing an outsourced model. In addition, many of the charges the company has recorded in the recent quarters should set the stage for a healthy revenue and bottom line consolidation in FY2008. Its Q1:FY08 results and guidance for Q2:FY08 are indicative of the company's FY2008 growth prospects (although the recent 3S Photonics situation may put a major dent in the company's revenue growth strategy near-term), mainly in terms of margin improvements and anticipated gains in market share.

Although the current environment in the optical component sector is a far cry from the peak of 2000, we believe the technological advancements that have already taken place will sustain the demand for Avanex's product. The specific areas that the new products address are the move to higher channel counts, higher speeds per channel and dynamic chromatic dispersion compensation on legacy fiber. The industry has already seen the move to higher channel counts and the demand clearly exists for 10 and 40 Gb/s transmission rates compared to 2.5 Gb/s. The need for the continued development of DWDM systems for 160 channels and beyond is quite clear and we expect Avanex to have the first-mover advantage mostly owing to its technological positioning. In general, the primary growth drivers for Avanex's products are the industry's need for higher channel counts, increased video content delivery, FTTx initiatives by Tier 1 Carriers and increased transmission rates and long-haul capability without the o/e/o conversion. Although we think that Avanex can continue to be profitable in view of its realigned operating expense structure, in view of the near-term weakness we rate the shares of AVNX Hold' and recommend investors accumulate the stock on weakness.

Industry Overview

The optical component industry has undergone a tremendous boom-bust cycle for nearly four years since 2000 and we believe it began to turn the corner in 2005. Activity in the telecom market has begun to improve since then, with some bumps along the way, and we finally saw carrier capex trending slightly upwards since the bubble burst in 2000. Although the optical component industry appears to have taken steps towards a recovery, excess manufacturing capacity still remains a significant issue among Avanex's competitors. Despite meaningful volume growth across the board, we anticipate the market to grow at around 18%-20% in 2007 as ASPs decline an average of 10%-15% y-o-y. However, given the level of consolidation in the component industry, we calculate that it has left it concentrated at 70% in the hands of the three large players: JDS Uniphase (JDSU), Bookham (BKHM) and Avanex (AVNX,). It should be pointed out that the component market appears to have stabilized at around $2.0 billion, down from $5 billion during the heyday of the telecom bubble.

Optical Networking technology came to the forefront in the 1990s with the introduction of a new scalable technology known as wave division multiplexing (WDM). This coincided with an unprecedented demand in bandwidth, spurred by (a) telecommunication de-regulation following the Telecom Act of 1996, (b) the growth of competitive local exchange carriers (CLECs) funded by overly motivated capital markets, and (c) the mainstream adoption of IP, including the Internet. These events engendered a huge bubble in the telecommunications industry up until 2000 and the optical component industry experienced a rapid burst of growth during this period. Demand from network equipment vendors and their carrier customers increased nearly five-fold in just a few years.

When the bubble burst in late-2000 component vendors were still ramping up capacity and were completely unprepared for the sudden implosion in demand. Industry order levels hit its lowest point in late-2002/early-2003 and they continued to be low given the excess capacity within the carriers' optical networks. Post-bubble spending on optical networking equipment has been driven largely by maintenance in North America and Europe. Couple of factors also helped in generating additional demand: (a) equipment orders in specific links or regions where growth in demand had absorbed excess capacity and (b) large optical build-outs in China and India, where these countries dramatically increased tele-density and began to deploy large optical backbones. In reality, the main reason the optical component players survived the downturn were the cash cushions that had been raised from the capital markets during the bubble period.





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