Does JDS + SDL = $ $ $?
Monday July 10, 4:00 pm Eastern Time--Individual Investor--
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Senior research analyst: Luciano Siracusano (07/10/00)
JDS Uniphase (NASDAQ: JDSU - news), which won government approval to acquire Etek-Dynamics June 30, waited all of four trading days before announcing its next block-buster takeover target: SDL Inc. (NASDAQ: SDLI - news).
On Monday, the company announced it intends to buy SDL for an estimated $41 billion. The offer, 3.8 JDS shares for each SDL share, valued SDL shares at $441.51, almost 50% more than SDL's Friday's closing price of $295.31. The merger, which will be accounted for as a purchase, is expected to close in December.
While we expect the deal will be dilutive to JDS's per share earnings by about 10% on a pro forma basis in the near term, management expects the merger to be ``accretive for stockholders from the time of the close going forward.'' JDS shares were down more than 12% in mid-day trading, with shares of SDL trading up $30, or a little more than 10%.
JDS has acquired 17 companies since 1995, including four in the past six months. By digesting Optical Coating Laboratories and Etek-Dynamics, JDS has been able to shore up the passive components side of its business.
Should it acquire SDL, JDS would further augment the considerable strength it already possesses as a producer of active components. Active components power, amplify and transmit photons through optical networks. SDL's expertise in designing and manufacturing active components is underscored by the more than 200 patents earned to protect innovations it has made in the areas of optical amplifier, pump laser and pump module technology.
SDL, which recorded $182.4 million in revenue and $25.2 million in net income in 1999, is on track to record as much as $400 million in revenue in 2000. The I/B/E/S consensus earnings estimates call for the company to earn $1.21 per share in 2000 and $1.66 per share in 2001.
Is SDL worth $41 billion?
Although that sum represents more than 100 times the sales SDL is expected to generate this year, we think the deal ultimately makes JDS even stronger.
One of the dynamics unique to the fiber optics industry right now is that advances in the supply of key technologies are actually creating greater demand for related components.
Consider optical filters and arrayed waveguide devices, which are key components for DWDM (dense wave division multiplexing) systems that separate light into different wavelengths, or channels, allowing for more data transmission through a single strand of fiber.
While this technology is a boon for the telecommunications industry, significantly increasing bandwidth, it also increases demand for the active components that power photon transmission through each wavelength.
SDL is uniquely positioned to benefit from this increased demand. The company is the worldwide leader in providing pump lasers for the subterranean transmission market.
By acquiring SDL, JDS believes it is acquiring a product portfolio that complements its existing offering and gives it the ability to engineer the design wins of tomorrow.
The purchase will increase JDS' workforce of 17,000 by roughly 10%. JDS will gain access to products that it does not currently produce such as the 980 nanometer pump module, which SDL does. By incorporating SDL's Raman amplifier, it will actually receive a technological upgrade.
Raman amplifiers, which help boost optical signals over long distances using installed optical fiber as the transmission medium, negate the need to seed or ``dope'' fiber with the rare Earth element, Erbium, which, when excited, amplifies light.
Although 10% of SDL's sales are to JDS, the combination of the two companies will likely result in synergies that create new production capabilities that each company, acting alone, would not have achieved. SDL's packaging capability, which is currently stretched to the limit, will benefit from the increase in JDS's capacity in the United Kingdom.
The longer-term value is likely to be unlocked as optical engineers from both companies come together to design next generation products. JDS management spoke on Monday's conference call about the direction the industry is heading in, ``Systems on a Chip.''
A combined JDS and SDL would be able to take 15 base technologies and combine them for next-generation optical networks. The goal would be to integrate more functionality onto a single chip, taking transmitters, optical amplifiers, optical attenuators and combining them with passive, light filtering components to create a small wafer-like technology that decreases cost, while increasing functionality and reliability.
Management also indicated that JDS, Etek and SDL were all on track to deliver sales and earnings results that exceed what Wall Street expects for the second quarter. The combined entity is on a $2.7 billion revenue run rate, which suggests that JDS, could actually record more than $3.9 billion in revenue in the June 30, 2001 fiscal year if the combined companies post 15% sequential revenue growth.
If one used the revenue multiple that SDL and JDS have traded at for the past year, 30 times to 50 times revenue, then JDS could easily carry a market cap of $120 billion 12 months from now.
Granted, JDS's share count will swell by about 300 million shares to 1.1 billion to accommodate the deal. If you assume a 22% net profit margin, excluding costs associated with the merger and the amortization of intangibles, such a valuation would imply a multiple approximately 140 times 2001 cash earnings of approximately $0.78 per share.
This yields a 12-month price target of roughly $110 per share, or about where it was trading over the past few weeks before Monday's announcement.
Once JDS Uniphase's stock begins to trade on projected fiscal 2002 earnings estimates, this issue will once again start to move like the JDS that investors came to know and love in 1999.
If you can wait that long, six to 12 months, then yes, we believe SDL is worth the $41 billion that JDS offered to pay.
Not surprisingly, the deal has also set a fire under the stock prices of other makers of fiber optic components. Avanex (NASDAQ:AVNX - news), Bookham Technologies (NASDAQ:BKHM - news), New Focus (NASDAQ: NUFO - news), Oni Systems (NASDAQ: ONIS - news) and Stratos Lightwave (NASDAQ: STLW - news) all rallied in sympathy with the news.
Although these equities are changing hands at hefty premiums to the sales they are expected to generate in the coming year, these component manufacturers will likely continue to trade as if they are potential takeover targets, as both JDS and Corning (NYSE: GLW - news) may continue to round out their product offerings.
On Monday, Reuters reported that Corning did look at SDL but that ``the valuation was pretty high,'' according to a Corning spokesman. SDL, which has a long-term supply contract with Corning, noted in the conference call that it intends to supply Corning for many years to come.
Manufacturers of fiber optic systems and fiber optics testing equipment also crested higher on the news. Both Ciena (NASDAQ:CIEN - news) and Sycamore Networks (NASDAQ: SYCM - news) jumped in mid-day trading, as did Digital Lightwave (NASDAQ:DIGL - news) and Finisar Corp. (NASDAQ: FNSR - news) .
We expect takeover premiums to be built into share values of these fiber optic stocks for the foreseeable future.
Investors should also keep in mind that as with the Etek-Dynamics deal, JDS Uniphase's bid for SDL will attract close scrutiny from the government.
JDS pointed to the plethora of companies that produce ``pump chips'' used in optical networking and, though vague on the share of specific markets that the new company would control, seemed confident that the proposed deal would clear regulatory hurdles.
If the deal doesn't happen, and SDL becomes part of another company, JDS Uniphase would receive a $1 billion break-up fee.
Bottom Line:
Although we expect JDS shares to drag a bit until the deal is consummated, the company is getting stronger with each passing day. While smaller fiber-optic stocks may provide more appreciation potential in the near term, we continue to view JDS as the core holding in the fiber optics sector for the decade ahead.
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