The end of an era?

JDS Uniphase, in five short years, has gone from doing tens of millions of dollars in revenues to doing billions. The company has transformed its business and the industry.

By Kevin Slocum and Robert Mandra

We often chose not to write about industry events because by the time you see our column, we worry about the timeliness of our thoughts. With the departure of Kevin Kalkhoven from JDS Uniphase, we could not refrain from making some mention of the news. After all, he was one of the early industry players to see this wonderful photonics opportunity coming down the pike. Better than just seeing it, he positioned his company to be one of the leading beneficiaries of the explosive demand most companies in the industry are grappling with today.

Most investors today would not recall that when Uniphase (now JDS Uniphase) went public in the fall of 1993, it was a somewhat obscure event brought by investment banks of similar note. The company was certainly a competent manufacturer of gas lasers, but it had plenty of company in its field. Management had put together a decent record of revenue and earnings growth, but it was hardly exciting. What was interesting to those who were drawn to the company were the goals of its CEO, who spoke of attractive vertical-market opportunities in the semiconductor and communications fields among others. The goal was to apply the company's laser expertise to building significant businesses supporting its target vertical markets.

The opportunity that eventually excited many investors was a new automatic defect classification system for semiconductor wafers that appeared to be essential to the future of the industry as it advanced to narrower and narrower line widths. Uniphase named the product the Ultrapointe, and the system provided the company with an exciting growth engine during the semiconductor boom of 1994 and much of 1996. The assets of the Ultrapointe business were eventually sold to KLA-Tencor in December 1998. But the defining moment in the company's corporate development came in 1995, when it was presented with the opportunity to buy the United Technologies Photonics Div. (UTP).

We later learned that Uniphase had outmaneuvered a number of other companies in managing to complete the purchase, a pattern of behavior it would repeat later in its acquisition life. What was remarkable about the transaction was that it sent Uniphase down a path that has today molded it into what we believe is the leading supplier of optical components to the communications industry. Some may consider it a lucky move, but we spoke with senior management at the time and they had a very clear picture of the important role the technology would play in solving bandwidth needs in the future.

UTP made lithium niobate-based modulators that are used to convert electronic signals to optical and also built optical-transmission equipment. The business grew by nearly an order of magnitude in just two years and zeroed management in on the communications market segment that has today emerged as its exclusive focus. A string of highly successful acquisitions ensued and now the Kevin Kalkhoven chapter at JDS Uniphase has come to an end, as well.

You can't really call it the end of a chapter; it's more the end to Act II. With it have come the questions about what lies ahead. Does the decision to depart signal a peak in the business? Have we seen the last of important acquisitions? People look at athletes and often speak of them getting out at the top of their game, and that feels like the correct analogy here, as well. JDS Uniphase has, in five short years, gone from a company doing tens of millions in revenues to one doing billions. It has transformed its business and the industry. How could you ask to go out on a better note than that?

The questions remain. Kalkhoven has left at the top of his game, but is the company also at the top of its game? We do not think that is the case. We expect to see the company do more acquisitions, and we believe this business and JDS Uniphase are far from a peak.

One of the real coups of JDS Uniphase has been its ability to hold the talent it has recruited as it has moved down the acquisition trail. Beyond all of the wonderful technicians that those transactions brought with them also came some pretty terrific businessmen, not the least of whom is Jozef Straus, who moved from co-CEO to the single executive in that capacity when the news broke of Kalkhoven's departure. Straus had a pretty good vision on his own at JDS Fitel prior to its merger with Uniphase, as did Charles J. Abbe at Optical Coating Laboratory before its merger with JDS Uniphase. Not to lessen his importance to the company, but we believe that the momentum behind JDS Uniphase and the core talent that remains are more than adequate to keep the company rolling toward $10 billion in sales within the next few years. So good luck to Kevin Kalkhoven in the next chapter in his life, and don't lose a lot of sleep all of you investors in JDS Uniphase as it moves into Act III.

Returning to the subject of photonics stocks in general, as SUPERCOMM began last June, the group enjoyed a sharp rebound based upon reduced concerns about things we can't control like what the Fed does to interest rates. There seemed to be a return to focusing on business fundamentals that you all know remain outstanding. Is that shifting of spirits apt to continue? We believe it will. The expectations of strong June quarter results reported in July will probably have produced a rally in the group that may give way to profit-taking in early August. This is a group that seems to respond to news, however, and the next bout of news will surround the National Fiber Optic Engineers Conference later this month. So if you read our column in the midst of a correction in the group, we would think about leaning against the tide and adding to your positions.

This year is turning out to be quite different than last year, as we predicted it would in January. If you have noticed anything in our comments, it should be that we believe the high valuations should lead to more opportunistic buying of shares during bouts of weakness, and if you have a reason to sell, do it in periods of euphoria. So far, the latter have come around major industry events and earnings reports, and the former in between. Underlying that thought is a continued view that industry fundamentals remain strong and are apt to continue strong for longer than most investors might guess.

Our list of favorite stocks shifts all the time lately due to the great volatility in the group. The truth is that we have 13 strong-buy rated stocks and only two with buy ratings. It is pretty safe to say that we like this sector broadly, and only get nervous when in vestors try to tell us that a company is in the optical-communications business when it hardly has any revenue exposure.

As we wrote this column, we were most optimistic on Harmonic and Finisar due to major price weakness from levels earlier in the year on stories that are basically intact and on Ciena due to our optimism about the prospects for CoreDirector in calendar 2000.

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 protected].