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JDSU and E-TEK: The Omens Are Good
It Is Certain
It's been a nail biting saga for investors following the planned merger of JDS Uniphase Corp. jdsu.com and E-Tek Dynamics e-tek.com.
The deal was delayed back in March, when the government asked for additional information from both companies to evaluate whether or not the merger would violate anti-trust laws outlined in the Hart-Scott-Rodino Act. But as the case is scrutinized, many industry experts say there is little to worry about.
"I think the odds are in favor of the merger going through," says Rich Schaefer, equity analyst for CIBC World Markets cibcwm.com. "It's a no brainer. It's more a matter of educating the DOJ and holding their hands as they walk through the issues."
JDS Uniphase has catapulted to the top of the optical components industry; its stock price has risen 419% since last July. In the last year the company has used its capital to go on a buying spree, beefing up its presence in almost every area of the market. But when JDS Uniphase announced a $15 billion merger with E-TEK, its arch rival in the WDM filter market, stock prices dipped as much as 5% as spooked investors sweated about anti-trust concerns.
Those concerns hinge on whether the merged mega-company would have too much control over the component market -- enabling it to shift the price of key optical components, and leaving system vendors like Alcatel SA alcatel.com, Lucent Technologies lucent.com and Nortel Networks nortel.com at its mercy.
"If you merge with your major competitor what happens to your customers?" says Jay Leibowitz, director of optical components for RHK rhk.com. "Why do you think Microsoft is in trouble?"
The Future Is Hazy
But first intuitions may not always be accurate. The optical component market is a complicated one to decipher, and can be sliced and diced in multiple ways. A decision as to whether or not the merger goes through will really come down to how the DOJ and the Federal Trade Commission decide to look at the market.
This is a knotty issue, say experts, because the over-all $16 billion market covers a huge array of components that can be broken down into three main areas: cable, active and passive components. The best place to start understanding how JDSU and E-TEK fit into the market is to work from the outside in and peel back each layer like the skin of an onion.
Starting at the most basic level, the two companies overlap in only one of the three areas---passive optical components. But within this slice of the market, the two companies dominate in at least one major technology area ---the production of WDM filter modules, which are used to split light into different wavelengths in WDM and DWDM multiplexers.
Peeling back yet another layer, there are three main types of filter modules used in DWDM and WDM multiplexing devices---Bragg fiber grating filters, thin film filters, and waveguide array grating filters. Together E-TEK and JDSU control about 90% of the thin film filter module market, which is by far the most popular technology used. But experts say that even though the two companies may have a lock in the thin film market, other competing technologies -- like Bragg fiber grating, or waveguide array grating -- can be used about as easily to accomplish the same end result.
"System vendors don't really care which technology they use as long as it gets the job done," says Stephen Montgomery, president of ElectroniCast Corp. a fiber optic consultancy group.
What's more, thin film filtering is not even considered the most cutting edge technology anymore. For example, thin film filtering modules only allow up to 16 wavelengths on one DWDM port. As more and more system vendors look to put 32, 96 and even 300 wavelengths in one device, the newer waveguide array technology, which handles more wavelengths per module, is bcoming the technology of choice. Currently, neither JDSU nor E-TEK have products in this emerging area; Lucent is the dominant player.
Ask Again Later
While waveguide array revenue is expected to out-pace the growth of thin film filters in the next five years, it is clear that in the short-term thin film filter technology will be used more often. And even though there are other players like Corning Inc. corning.com and smaller startups like Oplink Communications Inc. oplink.com and Iridian Spectral Technologies Ltd. iridian.ca that have the intellectual property to build their own thin film filter modules, they don't yet have the manufacturing capabilities to produce the volumes necessary to meet market demand.
This puts equipment vendors in a tough spot, say some experts. "For equipment vendors that have already chosen to use thin film with a product release date approaching, they don't have time to move to another technology or look for another qualifying vendor," says Leibowitz. "A few months before the announcement of the merger, Nortel announced that they had qualified E-TEK as its second supplier. Nortel is already one of JDSU's largest customers, how would you feel? Read between the lines."
On the other hand, others say that even though the two companies control most of the thin film filter market, there is room for competition not only from competing technologies, but also the system vendors themselves. Companies like Alcatel, Lucent, and Nortel all have their own component divisions, and many of the parts bought from JDSU are used to supplement the components that their own divisions produce. Further, Lucent, a large JDSU customer, announced in February that it was entering a joint venture with DiCon Fiberoptics, Inc. dicon.com , a passive optical component vendor that also produces thin film filters.
Furthermore, it could be argued that combining the two companies would benefit customers far more than it would hurt them by increasing production capacity and focusing RND efforts.
For investors the stakes are high. Those who have bought E-TEK banking on a thumbs up from the government stand to make about a 30% to 40% gross on their investment once the E-TEK stock is converted to JDSU shares. But if the merger is denied, these investors could lose their shirts, says one investment arbitrager who is cautiously awaiting the outcome. If the deal is called off, the E-TEK stock will most likely drop considerably as investors sell off their shares.
While investors worry about the potential outcome of the inquiry, industry experts say that it isn't unusual for the Department of Justice to look further into a merger of this size in an industry as complicated and rapidly changing as the telecommunications industry. Other high tech mergers like the Lucent and Ascend deal in 1995 were also put to the same test.
"What it really comes down to is whether or not customers feel that they will be adversely impacted," says Montgomery. "DWDM thin film filter technology is not going to be the only game in town and customers have plenty of other choices."
Information has already been swapped between the two companies and the government and a decision is expected within the next few weeks, says a spokersperson from E-TEK.
by Marguerite Reardon, senior editor, Light Reading
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