Mergers and acquisitions divorce rate is on the rise

The mergers and acquisitions (M&A) scene recently has been more remarkable for the deals that have crumbled than those that have been consummated. Component companies Infineon Technologies and Finisar, for example, announced an acquisition agreement, called it off, then amended it to include only certain segments of Infineon’s fiber-optic business unit. Oplink and EZconn, meanwhile, also terminated an acquisition agreement, citing recent market changes and competitive circumstances. Is this indicative of a larger industry trend? Why can companies no longer get along?

The industry has been expecting an M&A spree for the last two or three years, but it has yet to materialize-for several reasons, say industry insiders. First, the recovery took longer than most people anticipated, and they are still waiting for some positive sign. “People buying more products is the obvious one, but maybe people-the big customers-talking up futures. It’s still pretty depressed out there,” reports Drew Lanza, general partner at Morgenthaler Ventures (Menlo Park, CA).

Four years ago, market researcher CIR (Charlottesville, VA) placed the telecommunications optical components market at around $10 billion-and that was a conservative estimate, says CIR president Lawrence Gasman. Today, the optical components market hovers around $2 billion. “That’s not just a change,” says Gasman, “that’s a whole new industry.”

In this new market reality, components companies like Bookham and Avanex are struggling. Their stocks are depressed, and they are no longer flush with cash, notes Gasman. “When the optical boom turned to bust, you were still looking at Bookham, for example, with several hundred million dollars in its IPO war chest. Avanex had a lot of money too, and that’s all disappearing fast,” he says.

But that is exactly why companies consolidate in times like these, counters Lanza. “Their stock is depressed, but the price of these [companies they could acquire] is also depressed. If I were JDSU, I would be out there consolidating the entire world,” he says. “You can buy stuff for nothing. Even the guys who have good stuff you can buy for a reasonable price.”

So how do we account for the industry’s reluctance to consolidate? According to Winston Fu, general partner with U.S. Venture Partners (Menlo Park, CA), M&As work when two companies consolidate, “and one plus one is more than two. In a stagnant market or shrinking market, M&As are harder, because the pie is not growing. If the pie isn’t growing, the players tend to hold out longer.” Morgenthaler’s Lanza agrees, adding that the public companies are reluctant to acquire a company unless that company is profitable, and profitability is tough in the current market.

Despite the industry’s skittishness regarding M&A activity, Gasman says he’s not surprised the on-again, off-again agreement between Finisar and Infineon was finally consummated. The transceiver/transponder space is practically a commodity market now, he says, and in a commodity market what really counts is market share. At the end of the day, there probably isn’t room for more than two or three mainstream module manufacturers. “It makes sense for Finisar to buy [Infineon] just to boost their market share a bit,” Gasman surmises. “And it makes sense for Infineon to sell it because there is really no chance they are going to be able to establish a substantial market share.”

“I think what you’re seeing is that clearly there are still too many players,” adds Fu. “No one is profitable, so consolidation has to happen one way or another.”

Recent consolidation further up the food chain will likely affect the components industry as well. At press time, SBC Communications had announced its intent to acquire AT&T and Verizon followed suit with MCI, increasing the likelihood that Qwest or BellSouth will gobble up Sprint. If that happens, the industry structure in the United States will start to look more like Japan, where you have two key providers, NTT East and NTT West, and a couple of competitors, says Fu.

“I think it’s going to stabilize the industry,” he says of the SBC/AT&T merger. “It may not make it more competitive, but it definitely gives the IXCs some deep pockets and much more stability. This is good for the industry because this is where it all starts. The service providers have just been very slow to buy new equipment.”

Of course, the RBOCs are also typically slow to adopt new technologies. Historically, they tend to favor incumbent suppliers with whom they are familiar, so the incorporation of AT&T and MCI into the RBOC family may not be the best news for already struggling startups.

Though it may take more than a year to get all the necessary approvals, the SBC/AT&T merger could nevertheless spark a ripple effect throughout the industry. “Even the idea of a combined SBC/AT&T is enough to send other providers scrambling for partners or acquisitions, since an SBC/AT&T partnership would affect every segment of the telecommunications industry,” says Kate Gerwig, principal analyst, network services, Current Analysis (Sterling, VA).

Fu believes a similar ripple effect will occur in the components space as well. “If Oplink actually does something or Finisar does something, I think you’ll see Bookham, Avanex-whoever didn’t make that first move is going to react, whether right or wrong, by trying to make a move of their own,” he says. “I wouldn’t be surprised to see continued discussions and then a flurry of activity, because as soon as one company does it, all the others will feel like they have to do something.”

Various sectors in the component space also seem ripe for a rollup, adds Lanza. This is not so much an M&A activity as instead a handful of companies merging to control one particular aspect of the market. According to Lanza, there is a great deal of rollup talk circling around such sectors as optical transceivers and photonic circuits.

“A rollup in photonic circuits would be interesting,” he notes, “because there are three or four companies who have different pieces of the puzzle. Maybe they all need to be put together to create a company that actually has some profitability and a lot of intellectual property and would probably own that market,” he says. The fact that photonic circuits are an area where JDS Uniphase is weak might heighten the chances of success, Lanza adds.

In the meantime, the industry’s hesitation to consolidate may have a continued negative effect on the market. In a difficult economic environment, companies will also consolidate to hold prices higher, says Lanza. “There is the belief that economies of scale and scope allow you to cut your costs by increasing your revenue. So the impact of these people not rolling up the industry, not doing M&A, will be that we will continue to see price erosion and loss on the bottom line,” he contends.

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