Consolidation revisited

June 1, 2002

The next round of consolidation may suggest things are getting better instead of worse.


At the outset of this year, we made several suggestions of moves that we believed were sensible for the consolidation and restructuring of the optical communications industry. A couple of our thoughts came to fruition, yet anyone who went to the Optical Fiber Communications (OFC) Conference in March got a clear indication of just how far the industry still must go.

Companies are beginning to make decisions about their long-term future, and in many cases it is not because they are about to run out of money. One of the struggles that we will face with the recovery we are all praying for is that there are many companies with enough cash to survive the downturn without question. The more important question will be the relevance on the other side. We credit that thought to Fred Fromm, president and CEO of Oplink Communications, in the wake of our conversation following news of his company's plans to merge with Avanex.

Stability, spending to improve
Many investors consider consolidation a prerequisite for health in the communications business. We expect consolidation to break out as business stabilizes, and we think greater stability is about to hit. Business remains tough, but the changes on the margin are getting smaller whether you are talking about incremental capital-expenditure cuts or the deltas-versus-analyst estimates. March and April saw many of the stocks in the sector make new lows. Most carriers we reach are suggesting it took the whole first quarter to nail down spending plans. That had first-quarter spending at very weak levels. We don't expect the current quarter to be much better, although maybe with a little help from the economy, the June period might resemble the typically back-end-loaded anticipated March period that never was in 2002. The bottom line is that we expect carrier spending to modestly improve from this point through the end of the year.

That is apt to trigger more consolidation. Ciena/ONI, JDS Uniphase/IBM (transceivers), and Avanex/Oplink can be considered the early moves. We think there will be a lot more consolidation and that the next round will be more of an indication that things are not getting worse but instead getting better. We continue to suggest the possibilities are numerous.

Ciena recently traded for less than half the level it held when we first said it should be of interest to Cisco Systems. Life has been tougher for Ciena over the first half of 2002. Our position has been that they have the right products for a recovery, whenever the recovery gets underway. Yet, time is the enemy of technology companies, and in all likelihood the products Ciena sells today will go for one-third their current price for delivered performance in 18-24 months. Ciena has had enough experience to know the challenges and how to deal with them. The real question is whether the team in place has the stomach to fight it out and build a big company or will they consider selling if the right offer comes along. They bit in 1998, and we can't rule out the possibility that they could do so once again.

When discussing Nortel Networks, it is a little dangerous to take too much of a focus on optical since that is only a part of what the company does, but it is an important part of the future the company has identified. We have enough reservation about the company's long-term future that we question whether Nortel will stand on its own feet a couple of years from now at least in its current form. Therefore, what combination of partners that hasn't been rumored might make sense?

A Tellabs and Nortel combination comes to mind. Here you have two companies in a reasonable geographic proximity that would allow them to build a team at the top from the best of both firms. The customer mix would become more balanced. As well, the probability of successful products for a broader customer base would be higher in our estimation. And the name of the surviving entity is no struggle at all, "NorTellabs."

The biggest wildcard suggestion of all is General Electric acquiring Corning. The only reason we raise it as a possibility is because the GE's name came up when Lucent Technologies was shopping for buyers of its fiber business. If GE ever had a modicum of real interest, prices for optical properties have fallen sharply in the past six to nine months, with Corning trading at roughly half the price it commanded back when GE was considering the Lucent business. If GE was interested in Lucent's fiber business, why wouldn't it consider Corning? GE would get the global leader in fiber and cable, the leader in flat-panel-display glass, and the number one or two player in several other business activities. Fiber is not dead and Corning is one of the leading materials companies in the world in its areas of focus, much as GE is in its areas of business.

Corning management was aware that a telecommunications-focused business would be more volatile than the mix it ran prior to 1998. The current trough is the first real experience, and it has been painful. Lessons have been learned, and maybe next time will be different but probably not. Would Corning consider the stability of GE's more diversified business an attractive landing spot? The town of Corning would get its dividend back. Was GE's look at Lucent's fiber business just a passing interest in a distressed asset or was it doing due diligence? We don't mean to harp on consolidation, but we think it is a key ingredient to a return to health for the industry. 1999 and 2000 were a period of "opportunity inflation" in the communications industry. Too much money was chasing too few revenue dollars. A better economy will help us recover from the deflation that followed, but there are still too many players with not enough distinction for the opportunities we know today.

Kevin Slocum is a managing director and head of communications research at SoundView Technology Group (Greenwich, CT). He has more than 20 years of financial industry experience, including institutional equity research sales and analysis, and has been named to the Wall Street Journal's prestigious "Home Run Hitter" list two consecutive years. He can be reached at 203-321-7200 or [email protected].

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