Acquisition mania continues

May 1, 2000

By Kevin Slocum and Robert Mandra

It seems as though most times when we sit down to write this column the acquisition subject crosses our minds. We have tried not to over-emphasize the subject but so much has gone on in the last few months that we felt it had to be the topic of our discussion this month.

First, we want to update readers a bit on our latest investment thinking. We feel pretty good about our more bullish posture on the photonics sector at the outset of the year. As our deadline for the column approached, we looked at 15 stocks closely associated with the sector that were not the subject of a takeover bid.

The top quintile had delivered 260% price appreciation in the first nine weeks of the year, the second 214%, the third 135%, the fourth 78%, and the bottom quintile 55%. We were fortunate enough to have had most of our coverage rated a strong buy, which even the bottom quintile would seem to have deserved.

In the days ahead of the Optical Fiber Communications Conference (OFC), we began to pull in our horns a bit. Not because we were afraid something was about to go wrong with business, but rather because we felt the business needed a chance to catch up with the torrid pace of the shares. Our thought was that the stocks had discounted the late January reports of fourth quarter earnings, the positive effects of continued consolidation, and the fact the first quarter was tracking even better than most forecasts.

It also seemed as though the excitement associated with planned new-product introductions at OFC had probably been pretty well baked into share prices. That left the report of first quarter results as the principle driver for short-term gains in the shares. They would certainly be strong, but moves as strong as those noted here seemed to discount the expected results.

Our bet is that the next significant move in the group will center on SUPERCOMM 2000 in early June. The show tends to be more for system companies, and therefore we expect they will get the greatest benefit from conference news flow. But the tone of the conference is apt to be good for suppliers as well.

By the time you read this column, we may already have been proven wrong. If not, we would look for another few weeks of consolidation in the group before it once again pushes higher approaching SUPERCOMM and then again in anticipation of strong results in the June quarter.

If we are proven wrong on our more cautious short-term posture, it will probably have been due to further consolidation moves by the larger companies in the sector at lofty valuations. The January decision of JDS Uniphase to acquire E-TEK Dynamics, Corning's move on NetOptix, and Lucent's bid for Ortel played substantial roles in the hefty gains of the group in the first quarter. Investors seem convinced that any company doing anything in optical communications, including as little as filing a device patent, as sufficient enough evidence to warrant a multi-hundred-million-dollar valuation because of the potential of a bid.

How do you argue with that? After all, Corning's bid for NetOptix was valued at the time at about $2 billion in Corning stock for a company that had little more than a couple of million dollars in wavelength-division multiplexing (WDM) thin-film-filter sales in its prior 12 months of operation. We had said in our kickoff column for 2000 that we weren't certain that a business as narrow as just making thin-film filters would be sufficient to deliver great stock performance this year. We sure were wrong on NetOptix. We will add that we believe a unique combination of circumstances made this deal work for Corning and that investors should not expect a repeat deal with some other combination of players.

The other point that we are sure gives the speculators confidence is that the list of aggressive acquirers has also grown. Last year, the big buyers were Cisco Systems on the system side of things and JDS Uniphase in components. To a lesser extent, SDL, E-TEK, and Ciena made moves. But late in the year, there was a big step up in the valuation of the deals and the number of buyers. Nortel moved on Qtera, Corning surprised observers and bou ght Oak Industries, and we already mentioned Lucent and Ortel.

You put together the string of deals by these industry leaders, and the performance of the first quarter was not surprising. If you look at some of the stocks in the various quintiles we mentioned at the outset, the pattern is obvious. We didn't look at Lucent's share performance, because it isn't a pure play in the optical component or system sector.

Corning has significant exposure, and it was in the bottom performance quintile. JDS Uniphase is very nearly a pure play, and it was in the fourth quintile. SDL, which is considered both an acquirer and a potential target, was in the middle quintile. At the top were companies that only recently were discovered to have concerted efforts in optical-communication components such as Coherent Inc. or companies that investors believed could be takeover targets like Precision Optics or MRV Communications.

At one time, JDS Uniphase traded at a 50% to 65% valuation premium over all of the other companies in the optical-component group. As we wrote this piece, that premium had shrunk to 10%. We don't believe that the minimal disparity between a proven company and the raft of aspirant industry participants will last. Either JDS's shares will get up and go or the speculative fever that has fueled these other stocks will come back to Earth. We believe it will be a little of both.

One factor in this change could be a crop of new public companies that may begin to focus investors on the fact that we won't be supply constrained forever. There are new classes of products that should ease some of the constrained markets such as the WDM module market. Avanex had a very successful debut in February with a product in this vein, and we expect at least a half-dozen more initial public offerings before the end of the year.

Another catalyst could be if investors take a little closer look at what it would take some of these companies to make positive earnings contributions to an acquirer. We aren't aware of a buyer out there that isn't at least hoping to have a positive earnings contribution in the second full year of a buyout. Some of the prices in the market today wouldn't allow that.

We suppose that our comments were a long-winded way of saying that while more acquisitions are going to happen in both the optical system and component businesses, we believe that the speculation has gotten to a ridiculous level and will cool off. We expect the successful investments in the photonics sector over the balance of 2000 will be in companies that have achieved critical-supplier status such as JDS Uniphase and Corning or more narrow suppliers that are addressing emerging product opportunities. That could be an entirely new product category from startup companies or possibly from a company like SDL that could successfully execute on hot new product cycles like its 10-Gbit/sec lithium modulators and Raman amplifiers.
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 [email protected].

Robert Mandra is an associate 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 protected].