SDLI/JDSU:
Same thank you. A favor is owed! It's in the books. Whatever I can do to help.
Strategic rationale and analysis of pros and cons:
To date, JDS has employed a multi-faceted growth strategy: 1) expand its component portfolio and technology base, 2) integrate these components into modules, and 3) expand manufacturing capacity. The first stage of creating the broadest component portfolio in the market combined internal development with the acquisitions of IBM Zurich, Philips’ optoelectronics business, JDS Fitel, Epitaxx, OCLI, Sifam, Oprel, Cronos and others. The second stage has been aimed at driving the integration of these components into modules. Accordingly, the Company believes it can capture more merchant opportunities by servicing OEMs’ needs to reduce time-to-market in the face of exploding demand. Stage 3
consists of the rapid expansion of manufacturing and packaging capabilities, both through
internal efforts and acquisitions, mainly E-Tek. The SDL acquisition embodies all these
objectives, but most importantly adds complementary products, next-generation technologies, and
intellectual property. The combined entity should be better positioned to leverage the $23B 2003
market opportunity, according to market research firm RHK.
The benefits of this acquisition include:
JDS gains superior pump module technology, bolstering its EDFA business. JDS currently is
a leading supplier of Erbium Doped Fiber Amplifiers (EDFAs). EDFAs are a key DWDM
subsystem that amplify light in the optical domain. 980nm pump modules are critical
components in EDFAs. The most important metrics for these pump modules are power and
reliability. JDS Uniphase currently is a leader in pump chips (through its IBM Zurich
acquisition) and is ramping its pump module capabilities in Plymouth, England. Still, JDS
currently relies on SDL for a majority of its pump module supply and is a 10+% customer of
SDL, due to the superior performance of SDL’s pump laser products. Futhermore, SDL
recently began volume shipments of its next generation grating-stabilized 300mW+ pump
module – by far the highest performing product on the market. We believe JDS’ chip
business is better suited to non grating-stabilized applications, such as short-haul uses, and
SDL’s chip business is better suited for very high-powered grating-stabilized applications,
such as long-haul DWDM. As far as market share goes, we believe SDL had roughly 40% of
the $185M 1999 980nm pump module market, and Nortel and Corning (Lasertron) modules,
which mostly use JDS chips, accounted for about 50%. Competitors in the chip market
include Lucent (Ortel), Corning (Lasertron), Pirelli, Furakawa and Multiplex. Nortel,
Corning, Pirelli, Furakawa, and Multiplex manufacture modules. However, few if any of
these competitors can even approach the performance of SDL’s products. Over all, by
acquiring SDL, JDS gains the industry’s best 980 nm chip and module technology, which
should prove to be a substantial competitive advantage in its high-margin EDFA business.
JDS gains SDL’s crucial next-generation Raman technology and associated patent portfolio.
Raman amplification is a distributed optical amplification technology that is crucial for next-generation
applications and extends the performance envelope of optical networking in terms
of speed, reach, and channel density. For example, virtually every ultra long-haul and 40
Gbps design relies on this technology because of its low noise and high, distributed power.
Additionally, Raman amplification can be applied in the L-Band (between 1565 and 1605
nm), and also from 1300 to 1650nm. Accordingly, this technology can help system designers
increase channel counts. Although JDS Uniphase and Lucent have recently introduced
Raman products, we view SDL as the leader in this segment of the market with significant
time-to-market and power advantages. Additionally, SDL owns the fundamental patents to
the technology, which it obtained through its Polaroid acquisition (although Lucent has the
rights to many of these patents). SDL recently announced capacity expansion for Raman,
attesting to the strong demand for this product as next-generation ultra-long haul, high-speed
and density systems gain traction in the market.
SDL adds integrated optics capabilities, which are becoming increasingly important as
volumes grow. Through its PIRI acquisition, SDL gained key arrayed waveguide (AWG)
multiplexing/demultiplexing technology. This technology is becoming increasingly important
with an emphasis on higher channel counts and lower costs. DWDM systems essentially
multiplex (combine) and demultiplex (separate) a number of optical signals, each at a
different wavelength, on a single fiber optic cable. These systems can use various
multiplexing technologies, such as thin-film filters (TFFs), arrayed waveguides (AWGs), or
fiber Bragg gratings (FBGs). While TFFs and FBGs are manufactured in batches, according
to wavelength, AWGs are manufactured on wafers, usually constructed of silica. One of the
most important metrics for optical systems is insertion loss. The losses associated with TFFs
and FBGs per channel (one filter per channel) are low, but these technologies are often
cascaded. Consequently, as system channel counts grow, so do losses. Alternatively, the loss
in an AWG is essentially independent of channel count. This loss can be thought of as a
“fixed cost” associated with coupling the fibers to the AWG. So as systems continue to
become denser, AWGs make more sense, both from optical loss and manufacturing
perspectives. Waveguide technology can also be applied to other optical components, such as
variable optical attenuators (VOAs), switches, and splitters. Additionally, individual
components can be combined on a single wafer to construct integrated subsystems, such as
add/drop multiplexers. Overall, while JDS is already a leader in TFF-based multiplexers
(with the majority of its TFFs coming from OCLI) and the Company also has FBG
technology, PIRI adds AWG capabilities, essentially completing the mux/demux picture.
SDL’s Veritech, and Queensgate properties add technology. For transmitter and receiver
electronics, Veritech is a leader in optoelectronic modules for submarine and terrestrial
transmission applications. Through the Epitaxx acquisition, JDS has significant optoelectrical
receiver and photodetector products and technology. Furthermore, JDS is a leader in source
lasers and modulators. When combined with Veritech (already a supplier to JDS Uniphase),
JDS has virtually all of the technology needed for transmitters and receivers. Additionally,
with Queensgate, JDS gains channel monitoring, which uses tunable filter technology to
measure the optical properties of a signal (e.g., signal-to-noise, rejection, frequency, and
power), and feeds this information back to the system.
This acquisition is not without negatives:
Integrating SDL is non-trivial. While JSDU has been very successful to date integrating its
acquisitions, the combined company will have almost 19,000 employees in 39 sights in 11
countries. While we believe this sort of scale can be extremely beneficial to the Company,
this is JDS’ tenth acquisition (E-Tek, Sifam, Oprel, OCLI, Epitaxx, Ramar, AFC
Technologies, Casix, Cronos, SDL) in ten months, not including the combination of JDS Fitel
and Uniphase. It is the fifth multi-billion dollar combination that the Company has
undertaken in about a year and increases the risk of execution integration.
Valuation is at the high-end of the range. Terms of the acquisition upon as of Friday’s close
value SDL at approximately 55x CY:01 sales. When compared to the E-Tek acquisition
which was announced at about 30x FY:01 sales, this is rich. However, given SDLI’s industry
leading technology, we believe this premium is warranted. Ultimately, the litmus test for
relative valuation is whether or not the deal is accretive. JDS management estimates the deal
will be accretive upon close. Our CY:01 JDS EPS estimate is $0.71, though this does not
include E-Tek, which we believe is accretive. If we simplistically combine the JDSU and 4
SDLI models, we get about $0.08 of dilution to our CY:01 JDS estimates, or 11%. However,
this does not reflect the reality of the combination. We believe upside in the existing models,
benefits from product development and manufacturing synergies, and to a lesser extent cost
savings, will more than eclipse this mathematical dilution and yield accretion, possibly as
much as 5%.
Regulatory environment:
We expect JDS to file a registration statement with the SEC within 30
days. Under HSR, the DoJ has 30 days to either approve a merger or ask for more information.
Given the size of the merger and the complexity and importance of the technologies involved, we
would expect a second request, not unlike what occurred with E-Tek. The DoJ will have 20 days
from the time of receipt of the information from its second request to either approve or once again
ask for more information. JDS management believes the merger will close in December.
The DoJ will attempt to determine whether or not the combined entity will be able to increase
pricing pressure on its customers in any market into which the two separate entities currently
supply. For example, in the case of the JDS/E-Tek merger, the DoJ’s primary objection held that
the combined company would account for approximately 70% market for DWDMs with 16 or
fewer channels. In addition, the DoJ said alternative sources to JDS and E-Tek for DWDMs have
been producing at or near their capacity, in significant part because of restrictions in their access
to TFFs. To this end, the consent decree mandated the removal of the rights of first refusal from
the other TFF suppliers. We believe, similar to the case of E-Tek, JDS will have to make some
customer concessions with respect to contractual pricing and supply obligations to garner support
for the merger. However, we do not foresee any significant breakup decrees from the DoJ and
largely accept management’s guidance with respect to the likelihood of anti-trust approval.
Reiterate BUY:
We believe JDS’ motives for this merger were to augment production capacity
in high demand market segments, but more importantly, to add the world-class technology and IP
from SDL. SDL’s pump module products, capacity, and technology will ease internal JDS
bottlenecks and increase output. SDL’s AWGs, Raman amplifiers, and control electronics will
substantially strengthen JDS’ product line. Assuming that JDS is not derailed by regulatory
bodies, and further assuming that integration issues are overcome, JDS should become a
substantially more robust company, benefiting from greater production capacity and IP. We are
not changing our estimates until the deal closes, and reiterate our BUY rating for JDSU shares.
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