New age of investment is dawning

The last year has seen Agere Systems, Nortel Networks, Alcatel, and Corning all make the decision to exit the optical-component business. All four companies had strategic reasons to be in the market, yet when the going got tough, they sold their units in deals structured in a manner that said they were desperate to get out. When you look at the collection of companies that were at the heart of the supply chain to the optical boom that went bad, only JDS Uniphase remains.

When speaking to investors these days, JDSU is quick to turn its attention to the non-communications aspects of its business; something many industry observers tell us is responsible for the loftiest stock market valuation among its piers. We want to challenge that view based on what we are seeing in the stock market in recent months when companies make critical decisions. We would argue that JDSU's value is a reflection of a strong balance sheet as well as investor understanding of where the company is headed.

One of the nearer-term moves we will use to demonstrate our point was the decision by Avanex to strike a deal with Corning and Alcatel Optronix to consolidate their optical-module activities under Avanex operation. Avanex promptly doubled in the trading session that followed the news despite picking up business units from its partners that were expected to continue to rack up significant cash losses. The combined entity also faced a very uncertain timeline as to when its business would recover, particularly since its current customer base was substantially driven by the long-haul transport market.

The move was even more remarkable when you look at something called enterprise value, which takes a company's trading value in the market after stripping away cash. Prior to the Avanex consolidation plan, its stock was trading at a negative value. That negative value was equal to three times the company's current annualized sales value, putting it at a substantial discount to the approximately $140 million in cash that it held in the bank. When news of the consolidation broke, the enterprise value for Avanex's combined businesses turned positive. Avanex moved from being a company that people assumed would have to pay money to extricate itself from its misery to one with a value substantially ahead of cash, even though it was clear that the new business still faces a mountain of uncertainty.

The news that played so well for Avanex also played well for Alcatel and Corning. For them, the impact was less profound, but both stocks were up in the ensuing days in recognition that the companies had followed through on plans they had previously disclosed to investors. We are beyond the day when investors are interested in chastising companies for reversals on prior strategic plans. Most of those investors have sold and moved on to their next investment idea. New investors are now watching to see whether managements are going to do what they say they're going to do or if they're just going to idle away cash balances, creating little reason for excitement of any kind.

There are other companies like Avanex, notably New Focus and Oplink. New Focus has made its exit from telecommunications clear, and that has been somewhat helpful to the stock. But there are more than 200 million other reasons investors are unsure of the situation. That amount of money is enough for New Focus to make wholesale changes to its organization.

The company has said it would like to make acquisitions that are complementary and accretive to its non-telco optoelectronic activities—it's unclear just how many of those activities exist. So instead of generating interest in the marketplace, the stock trades at a value that appears to reflect the market's collective wisdom of the cash that would be left after what was saleable is sold and the rest is shut down. Oplink is in a similar situation.

Our point is that the value of companies competing in the market today may have more to do with investors knowing where these companies are headed than it does with the attraction of where they are headed. Agere's stock is up since it left the optical aspects of its component business. Emcore and Triquint are likewise up since they landed on the receiving end. Nortel is up since it sold NNOC to Bookham Technology and Bookham is up as well.

The wisdom of all these decisions will be determined in the next two or three years, but to sit and do nothing limits options. These days, investors seem more willing to give business managers the benefit of the doubt for showing the nerve to make decisions.

Just as we seem to be in a different phase of how investors are looking at businesses and their managers, we think there is a transition underway in the consolidation landscape. Most of what we have witnessed over the past year are desperation sales to buyers without an interesting future. While that phase may continue, we think it is in the late stages. The next phase will be strategic mergers, which we would characterize as moves to bolster market reach and penetration as well as expanding the acquirer's addressable market.

Ciena is one of the few companies in the sector that has been vocal in this area. Tellabs is another company that has been following this course for some time. More companies are destined to practice this philosophy.

Kevin Slocum is managing director in investment banking 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 kslocum@soundview.com.

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