Defining moment for optical components
First, JDS Uniphase and SDL, then Nortel Networks and Corning. And there may be other deals looming on the horizon.
Is any merger too big to imagine?
BY KEVIN SLOCUM and ROBERT MANDRA
In a move that totally caught us off guard, JDS Uniphase (Nepean, Ontario, and San Jose, CA) announced plans to merge with SDL (San Jose). As we noted in our last column on the changing of the guard at JDS, we had expected the company to re-emerge in the battle for investor attention with gloves on, ready to make further acquisition moves. We in no way expected management to go into action armed with a medicine ball instead of gloves. If successful in completing the transaction, the company will become a juggernaut in the optical component and module market.
We, as well as others in the Wall Street community, have expressed concerns that the deal will be at least as challenging as the E-TEK Dynamics transaction. These concerns center on the combined company's high market share of the 980-nm laser-diode mark et. These devices are the guts of most pump modules used in erbium-doped fiber amplifiers. Management focused more on its share of the packaged devices or the pump modules, where JDS today has a nominal position and SDL is among the leaders but certainly has competitors. Given that focus, it may be that the company would be willing to surrender one of the asset bases in 980-nm lasers.
The way management describes it, the prize is worth the challenge. Not that anyone should be surprised, but JDS seems remarkably confident that it will be able to secure all of the assets of SDL. This posture ignores Wall Street concerns that some concessions may have to be made. The track record with E-TEK gives JDS credibility, and we must admit that we emerged from our meeting with senior management the week following the announcement with a higher degree of confidence than when we entered. But to use an example from one customer with whom we spoke, the same sort of optimism was offered after MCI WorldCom made its play for Sprint.
Maybe the key is the lengths to which management is willing to go to get the deal done. It was clear from our discussions that executives did not want to send any signals in that regard, but it was also clear they have considered a number of scenarios, some that might include an asset sale or two. Somewhat comforting in this set of scenarios was an unequivocal view that the deal could be delivered as an accretive transaction even if everything doesn't go JDS's way. That substantially reduces our anxiety about the combination.
That doesn't necessarily answer the anxieties of the companies' customers, however. At the time, we were equally surprised to learn that at least two other bidders were in the fray, including Corning (Corning, NY). We thought this fact would be where customers might take some comfort-that there are more than a few companies with an interest in the optical-components business serious enough not to blink at a deal valued well over $30 billion.
Then the news broke-just as this issue was going to press-about the discussions between Corning and Nortel Net works (Brampton, Ontario). Word of a combination where Nortel's optical-components business would have been valued at as much as $100 billion staggered share holders on both sides of the story. Within a week, talks were broken off, from what we heard, over control issues. We would have loved to have seen the combination because of the balance it would have created at the top of the industry. That assumes that Corning would have been in the driver's seat, of course.
What have we learned? In the case of Corning, we don't believe the company would have gotten engaged in these discussions unless management had strong feelings they could deliver a deal to investors that was good for all of its customers and shareholders. That probably tells us that the financial outlook at Corning is stronger than all analysts are forecasting. We felt strongly enough about that point to return the shares to a strong buy during the bout of weakness that followed the rumored discussions.
Nortel opened the kimono in the midst of the deal rumors by disclosing that its optical-components business would deliver $2.5 billion in revenue this year, up from what sounded like roughly $1 billion a year ago. It further indicated it would spend $1.9 billion to expand optical system and component capacity to support more than a doubling of its business in the subsequent 18 months. That is a pretty potent expectation for the industry leader and says a lot about the likely continued momentum in the sector in the coming year.
Maybe the best signal that the deal wouldn't stay on track were comments from John Roth, Nortel's CEO and president, that he was worried about the consolidation in optical components. His comments seemed to imply that Nortel felt a need to have control of its component situation. Corning probably could not accept that position. In the end, we see a higher antitrust bar to be cleared by JDS, but not an insurmountable one.
It all makes you wonder. Is any deal too big to imagine or even have come to fruition in the photonics business? We still look at Cisco Systems and believe it needs to have a stronger position in the optical-systems market. With Ciena's improved momentum, growing customer base, expanding product portfolio, and accelerating financial performance, can it be ruled out that it might end up a target? We believe Cisco could pay a healthy premium and still see shareholders reward them for stepping more aggressively into the optical-systems business. The sector is dynamic and, frankly, we can't rule out any combination.
As you pick up this column, we will all be marching around NFOEC getting the latest dose of how wonderful everything is. Events have been great investment performance drivers for the optics companies. The ends of events have not. Our focus through the summer months has been on a shorter list of companies, including Ciena, Corning, Finisar, and Newport. We have had a strong buy rating on Book ham and JDS Uniphase but have been pounding the table a little less emphatically-in the former in stance because the business seems to need a little time catch up to its share price. In the case of JDS, our greater short-term reluctance has been the overhang of the regulatory review of its combination with SDL. Get the deal done and it will be off to the races, but management isn't looking for the process to be completed until late in the year.
It is not unusual for the fall to be a little challenging for technology stocks. We are not expecting any great challenges for the fiber-optics industry other than that of the struggle to keep up with demand. We would not, however, be surprised to see the stocks struggle a bit in the weeks ahead before regaining their legs for a final run into year-end.
Kevin Slocum is a managing director and communications research analyst for Wit SoundView (Stamford, CT). He has more than 18 years of financial industry experience, including equity research, sales, and analysis. He can be reached at (203) 462-7219 or kslocum@witsoundviewcom.
Robert Mandra is a principal in investment banking with Wit SoundView (Stamford, CT). Previously, he was an optical engineer with MIT Lincoln Laboratory for nine years. He can be reached at (203) 462-7361 or email@example.com.