Buyers and sellers

Aug. 1, 2007

by Stephen M. Hardy

As I write this at the tail end of July, the trading deadline for Major League Baseball is only a few days away. Since senior editor Meghan Fuller and I like baseball and love the Red Sox (we’re based in New Hampshire, after all), the impending trade deadline has given us plenty to talk about. Like baseball junkies everywhere, we’ve spent the last few weeks trying to sort out which teams are far enough out of the playoff race to be sellers and which clubs rate their prospects for success highly enough to pull out their wallets and make a purchase or two. Needless to say, we’re happy to place the “Sawx” in the “buyers” category and we’ve whiled away a few minutes here and there (during non-office hours, of course) in speculation about what acquisitions, if any, the team might make.

As our “Analyst Corner” this month points out, similar discussions have begun in the optical communications space. Increased carrier spending on optical technology has led to a positive turn of fortune for most companies in the industry. Market leaders have either returned to profitability or can at least see it on the near horizon. Component/subsystem companies such as Optium and Opnext and system houses such as Infinera have even launched IPOs successfully. The positive momentum has finally propped up company valuations in several key instances.

The environment for mergers and acquisitions in the optical communications space hasn’t appeared this fertile in years. Therefore, companies that have survived the downturn to enter this new era now face an interesting question: Are you a buyer, a seller, or happy to maintain the status quo?

The sources for this month’s article point out that cash-flush companies operating in the black have the most flexibility when it comes to answering this question. Such companies can build market share or portfolio breadth by acquiring assets. If they don’t see mover-and-shaker status in their future, they could present an attractive takeover target to a larger player and leverage their acquirer’s scale.

For most other companies-and, let’s face it, how many companies in optical communications are both cash-rich and profitable?-determining their place on the M&A game board isn’t so easy. However, correctly determining that position is obviously an essential part of any corporation’s strategy, particularly for venture-capital-backed private companies whose investors have hung in there since early 2001 and are starting to get restless.

Valuation is the key metric for both investors and company board members in pondering this question-and based on what I’m hearing, properly determining fair valuation is particularly difficult for companies founded during the bubble era. The start of this century saw valuation expectations that naturally led to scores of startups-and those expectations have no chance of being met anytime in the foreseeable future.

So once reason begins to creep into valuation discussions, as it appears is happening with increasing frequency within these companies, how much should expectations lower? One popular method for determining current valuations is to look at what the recent IPO companies achieved and extrapolate from there. But, as Greenwich Technology Advisors’ Kevin Slocum pointed out to me, the danger with this exercise is that there’s a reason those companies could go public and most others can’t. The trick is recognizing those differences and adjusting company comparisons accurately.

Valuation, of course, combines profitability and growth potential. It’s easy to demonstrate whether a company is currently profitable. It’s slightly more difficult to determine how quickly near-profitable companies can get over the hump, particularly when it comes to evaluating internal pathways (like cutting costs) to that goal. But growth potential clearly represents the trickiest parameter to measure-and I’m not convinced the industry has a handle on this problem.

Therefore, I believe that while the number of potential buyers in the optical communications space will continue to grow, the problem of establishing valuation will slow M&A activity. Companies that have survived the downturn now have new incentive to hang in-their valuations may go up with the rest of the market. Buyer insistence that their new acquisitions be both cash-flow positive and at or near profitability also will reduce activity.

So we’ll have companies that position themselves as buyers, and others who position themselves as sellers. But the net effect of the environment in which they will negotiate will result in a lot of companies just standing pat.

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