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We are downgrading PairGain Technologies shares to BUY from STRONG BUY based on the narrow margin for error in the upcoming first quarter results. According to the terms of PairGain?s pending merger with ADC Telecommunications (ADCT $45 1/2), ADC has the right to terminate the merger unless PairGain reports revenue of at least $55 million in the first quarter, including $5 million in Avidiar evenue, and an EPS loss of no more than $0.03. This is in-line with our revenue estimate and a penny better than our EPS estimate, but in-line with consensus. While we think PairGain should be able to hit the bogies specified under the merger terms, the lack of any margin for error, particularly for a company that has come in under consensus results in the last two quarters, makes our prior STRONG BUY rating inappropriately bullish. The merger was announced on February 23 when, presumably, PairGain management did not have full visibility into the quarter.
At the end of the day, we still expect the deal to close. If it does, there is still about a 9% arbitrage gap for PAIR shareholders based on the 0.43:1 PAIR/ADCT exchange ratio under the terms of the merger. In fact, we think that ADC would still close the deal even if PairGain does not hit the first quarter financial targets. With ADC?s historic product strengths in cable and fiber-optics, we think PairGain fills out the portfolio with a DSL product line.
PairGain appears to have taken one step forward and one step back in its Avidia DSLAM business during the quarter. Based on information we gathered from a number of participants at last week?s DSLcon conference in San Jose, we think that PairGain stands to lose @link, its first and largest announced Avidia customer, some time over the next year. In a presentation at DSLcon, an executive from
@link indicated that the company would migrate toward a single DSLAM vendor utilizing the UE IMAS from Nortel Networks (NT $121). On the other hand, it appears that PairGain has scored a major win in Europe with a major CLEC, First Telecom plc, which has reportedly agreed to deploy Avidia DSLAMs across its 800 CO network buildout. While we view these developments as a net neutral over
the next year, if @link does take fewer Avidia shipments than expected in the first quarter, it could leave ADC an out.
We continue to rate the shares BUY for a number of reasons. First, despite stringent deal terms, we do expect the merger to close. Currently, PAIR shares are trading 9% below the value implied by the merger terms. Second, while we do not follow ADC, based on theresearch we have done, we believe it is a solid company that will be uniquely positioned with products in all major broadband equipment
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