Is there a merger in your future?

If it seems that your customers, suppliers, or even your competitors are acting unusually friendly toward you recently, it may not be your imagination. Merger mania has hit the photonics industry, and your competitor may very well turn out to be your parent in the near future. We at SoundView have been getting an increasing number of calls from companies--some simply to ask questions, others somewhat more urgent--regarding their prospects of gaining interest from potential acquirers. Why the sudden interest in mergers and acquisitions (M&As) in the photonics marketplace?

The current level of valuations in the photonics sector certainly is a major factor. With the market capitalization of some firms reaching as high as 12 times next year's sales, public photonics firms have a richly valued currency with which to make acquisitions. Similarly, many private firms not yet ready for the public markets see M&As as a means of benefiting from these high valuations while the market is willing to support them. As any investor in the high-tech marketplace knows, market values can rise and fall quickly, so many smaller firms are choosing to act now rather than place their bets on the future of this volatile market.

Another significant factor is the rise of independent suppliers. For many years, the optical-component market was dominated by a small number of vertically integrated companies like Lucent/AT&T and Nortel. But heightened competition, cost pressures, and increased network complexity are forcing system suppliers to focus on system design, where they can more effectively differentiate themselves. Additionally, system suppliers are growing increasingly weary of being dependent upon their competitors for components. As a result, vertically integrated firms are increasingly looking toward independent suppliers for their components. Furthermore, the increasing complexity of today's dense wavelength-division multiplexing (DWDM) networks is creating a corresponding increase in the number and complexity of the fiber-optic components used to build them. System suppliers are turning to their vendors to provide a growing array of components with higher levels of performance and integration of functions. Incumbents and, increasingly, new networking startups do not want to buy individual parts that they have to assemble into modules themselves. They are demanding complete modules and solutions from their suppliers and are further asking that product development and delivery occur at unprecedented rates.

To fill these needs quickly and effectively, firms are using M&As to broaden their product lines, maintain technology leadership positions, expand upon their core competencies, and provide solutions at reduced time-to-market. The most obvious example of this is the recent merger of JDS Fitel, a leader in the passive-component market, with Uniphase Corp., a leader in the active-component marketplace. The creation of JDS Uniphase potentially provides "one-stop shopping" for optical components and paves the way for increased and accelerated integration of active and passive functions in single modules. It was, perhaps, this merger that "woke up" many of those companies now seeking parents or siblings.

Finally, the limited number of attractive target companies in any one photonic-technology area is also a likely driver of recent M&A activity. Unlike the computer industry, where there are often a significant number of vendors of hardware products, there is a much more limited number of photonics firms which can provide the WDM and other components needed to build today's high-performance optical-communication networks. Acquiring companies with leading technologies not only broadens the acquiring firm's product line and decreases time-to-market, but also provides a barrier to entry for would-be competitors. For the target firm, this strategy provides an attractive environment in which to achieve maximum value.

An engagement we are now concluding at SoundView serves as a good example of the motivations both sides of an M&A transaction consider in today's market. We are representing a small photonic-component manufacturer whose products in many ways are one to two years ahead of their competition with respect to performance. These products permit network suppliers to build networks with significant performance enhancements that ultimately translate into higher bandwidth at lower cost. Their customers have expressed great satisfaction with the products they have purchased. You would think that the combination of high-performance products and satisfied customers would indicate a rosy future for this company, but there were significant challenges facing this firm.

This company's management recognized that, despite their on-going product development efforts, their competition (many of whom have much larger financial and other resources to draw upon) could eventually catch up. Furthermore, this company's small size alone was limiting its success. It had extremely limited sales, marketing, and manufacturing capabilities, which was inhibiting its growth. Several times, the company had to turn down requests for quotes on unit volumes it could never hope to meet. Among the most frustrating challenges the company faced on a regular basis was being told that although its products passed all qualification tests and performed excellently, potential customers could not risk making their system dependent upon a product from a small company. Despite general approval of its products' performance, many of the company's potential customers expressed concern about designing-in product from a small supplier whose future was unknown.

Additional signs in the industry were also indicating a difficult path ahead. As mentioned earlier, the announcement of the merger of JDS Fitel and Uniphase was the clearest sign yet that a diverse product line and component-integration capabilities were going to be needed to compete in the marketplace. Management at the small photonic-component manufacturer considered all the challenges that lay ahead with respect to building a sales force and expanding their marketing efforts and manufacturing capacity. While it was not impossible to do these things, they realized that in the process they could lose their most valuable asset: time-to-market advantage.

Ultimately, the company chose to find an acquirer. The logic was that the value of this company's technology would be much greater if married with the sales resources, marketing muscle, and high-volume manufacturing capabilities of a larger firm. From the perspective of the buyer, acquiring a company with leading-edge technology but little other overhead was an efficient means of extending its technology leadership position and reducing time-to-market on products they would have been forced to otherwise develop on their own to remain competitive. All things considered, this transaction made a great deal of sense for both parties and exemplifies the goals of many other companies we have met.

Robert Mandra is an associate in investment banking with SoundView Technology Group (Stamford, CT). Previously he was an optical engineer with MIT Lincoln Laboratory for nine years. He can be reached at (203) 462-7361 or rman [email protected].

Kevin Slocum is a managing director and communications research analyst for SoundView Technology Group (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].