Very nice analysis of TLAB/CIEN by Mike Cammarata (HOOFBEAT newsletter)
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HOOFBEAT 980824 -- TELLABS/CIENA SPECIAL REPORT
Most major mergers go off without a hitch. The Tellabs/Ciena merger
will be recorded in the annals of history as one of the exceptions. A
major exception. In fact, I can't remember the last time a major
multibillion dollar merger has gone this wrong. There are many reasons
behind Friday's debacle and I intend to pull back some of the shroud of mystery surrounding what may only be second place to the
Worldcom/MCI/BT/GTE affair on the Weirdness Scale.
Ciena is the market and technological leader for DWDM (Dense
Wavelength Division Multiplexors - break a single Fiber Optic strand
into many virtual 'channels'). Ciena was really first to market with a
16 channel system, the MultiWave 1600. Worldcom and Sprint became big
customers, forming 90% of their revenues. Internet traffic is doubling
every 4 months and Bandwidth needs are soaring. Multiplying the capacity
of long haul fiber optic lines by a factor of 16 by adding a 'BOX' at
either end was nirvana to the Carriers and Kryptonite to Corning (a
maker of fiber optic cable). Frankly, laying new cable is very expensive
and Carriers would much rather get greater efficiency out of the fiber
already in the ground. Hence, Ciena soared on what seemed limitless
growth, yet in all markets, growth and margins like that attract hungry
competitors. Now, everyone is claiming to have some sort of DWDM product
available or coming soon. Lucent is very upset that they tinkered too
long in the lab and let Ciena run away with an installed customer base.
So, Lucent released their 16 channel solution. Then, Ciena released
their 40 channel solution in March of this year. To date, Sprint, Hermes
Railtel Europe, and Digital Teleport are running the 40 channel systems
in their production networks. Keep in mind, these things take months to
properly evaluate and qualify on the customer side. Ciena has also
released a 24 channel Metro solution for shorter distances and a 24
channel Firefly. Bell Atlantic in March of this year announced that
Ciena would get half of their DWDM orders for the next 5 years.
Lucent was spun off from AT&T in October of 1996. Some Lucent
engineers are still working in some AT&T buildings and vice versa. AT&T
executives still hold large quantities of Lucent stock, which has
appreciated nicely during this time. AT&T and Lucent still work like
hand and glove for the most part so it is no surprise that AT&T was the
first customer for Lucent's DWDM 16 channel product. Lucent announced
months and months ago that they have an 80 channel product in the works
that will be ready by the end of 1998. (Remember how long it takes for a customer to eval new systems). Last year, AT&T announced that they would
evaluate Ciena's 16 channel system as a second supplier to Lucent. This
was intended to assure supply and put pressure on Lucent's pricing. It's
been over a year now. They tested and tested. They asked for customized
software to be catered to their requirements. They tested. Now AT&T said
that they wouldn't award Ciena a secondary supplier contract for the 16
channel system since they are now only interested in higher channel
systems. Well, Ciena is the only company with a higher density system
out there, namely the MultiWave 4000, their 40 channel system which has
been up and running for 3 separate customers for months now.
One would naturally think that they would want to begin testing the
MultiWave 4000 system right away. Ciena will be releasing their 96
channel system in the first half of 1999 to compete with Lucent's 80
channel system that will allegedly ship before the end of 1998. However,
Lucent's 80 channel system has little in common with their 16 channel
system and would require a longer eval and debug period than Ciena's 96
channel system which is primarily based on the already debugged 40
channel MultiWave 4000. Hence, they should both be ready within
approximately the same time period, give or take a few months. By
testing the 4000, they would be getting a jump on the 9600 and have a
chance to debug all that custom AT&T software.
The Tellabs/Ciena merger was announced on 6/3/98 as a 1 for 1 stock
transaction. The shareholder vote was scheduled for Friday 8/21/98.
Negotiations began back in April of 1998 and the 2 companies have been
working closely ever since. Ciena originally had problems when Worldcom
decided to scale back their purchases in March due to their expected
merger with MCI. That announcement had sunk Ciena's stock since Worldcom
was about 40% of their business at the time. Once the merger went
through and an adequate assessment of their needs could be prepared,
Worldcom would be back in force purchasing away. This hit to the stock,
however, convinced Pat Nettles, the CEO of Ciena, that they really
needed a more diverse customer base, a larger sales force, and more
product depth and breadth. A merger was necessary and Tellabs was
interested. Tellabs was interested because their business has been
booming for years but is now peaking. Tellabs needs to be heavy into
Optical Networking and needs to be there now. Problem is, they were a
little behind in the lab. So the merger allowed Ciena to get a larger
customer base with a larger salesforce that already had extensive ties
with the Carrier population. Tellabs got the market leading technology
it needed to move forward.
In the interim, there was a mysterious 'Company A' that put in a
counter bid for Ciena as a pooling transaction. (The pooling part
excludes Lucent). Cisco and Ciena announced a Grand Strategic Alliance
on 4/20/98, uniting their GSR 12000 routing switch to Ciena's DWDM
equipment directly. Two weeks later, an Executive from Company A
ndicated an interest in pursuing merger discussions. One week later,
Company A made a formal offer. It is believed that Company A was Cisco.
Ciena ultimately decided to go with Tellabs since their salesforce had
deeper relationships with the Carriers and RBOC's than Cisco. This was
Ciena's prime concern to begin with. Tellabs was so concerned that
Company A would make another Counter Offer, that they built into the
Merger Agreement a $200M penalty in case Ciena broke off the merger to
pursue another combination. Tellabs wanted Ciena, Company A wanted
Ciena, Tellabs had to pay up with a 1:1 ratio to make it happen. None of
this made Lucent very happy. If Ciena merged with Tellabs, they would be
able to easily sell their DWDM solutions globally and to every RBOC,
using Tellabs experienced salesforce. That was not the desired outcome
for Lucent.
So, as we've said, AT&T suddenly decided they didn't need a second
supplier for 16 channel systems, even though they played with Ciena's
equipment for more than a year and had extensive custom work done for
themselves. Some people believe that Lucent cut a good deal on 16
channel systems to make that happen. This news helped lead to an
earnings shortfall which was then announced over a week ago. It was also
announced that special pricing had to be cut to one customer (Sprint
probably) and a major $25M order didn't come in. The right and ethical
thing to do was publicly announce that and have a Conference Call. At
that Conference Call, Mike Birck, CEO of Tellabs was present and
reassured that the boards of both companies were committed to going
forward with the transaction as it stood. He made perfectly clear that
Tellabs was after the technology and realized that it would take the
synergy between Tellabs salesforce and Ciena's products to make this
ultimately accretive to earnings. This announcement did introduce some
uncertainty into the picture about how the big institutional investors
would vote their Tellabs shares on 8/21/98 at the Shareholder Meeting.
Before we go on, we must go into the world of Arbitrage for those who
may be unaware. Whenever one of these mergers is announced, Arb guys
that work for Major Firms buy the shares of the acquired company and
short (sell) the shares of the acquiring company and hope to profit off
the spread. They carefully monitor the likelihood of the deal going
through and adjust the level of the spread accordingly. If it is likely
to go through, the spread will be narrow. If unlikely, the spread will
be wide. When this merger was announced on 6/3/98, the Arb guys big and
small bought CIEN shares and shorted TLAB shares and performed similar
positions in the Options market. Lots of regular Ciena shareholders sold
out at the higher prices and the Arbs helped to close the spread to
within a point between the stocks. The Arbs work with really large
numbers of shares or options so that even a small spread can be quite
profitable. So you have a lot of Arbs with monster Long positions in
CIEN and monster Short positions in TLAB and they watch the companies
like a hawk for the slightest sign of any problems with the merger. They
watch and they calculate and they watch. If the merger closes, they earn
the spread times by how large their position was. If the merger doesn't
close, they are in the absolute wrong position and will be killed. This
necessitates them to sell off completely at the first sign of trouble to
avoid getting burned, ala MCI and British Telecom. Well, after the first
CC, some of them sold but both boards were still 100% behind the
original deal. The spread widened to a couple of points, but started
closing again as the 8/21/98 date approached. The spread reached less
than a point the day before.
Lucent really, really, really didn't want this transaction to happen.
Lucent wanted Ciena to stay by itself where it would be easier to
defeat. Divide and Conquer. In any Homicide, the detectives will look to
see who had Motive and the Means to commit the crime. Lucent had the
Motive, and it had the Means. I'm going to speculate for a moment on
something concerning which I have no proof. Please indulge me. I
speculate that Lucent said to AT&T, "Our 80 channel system is almost
done, what if we offer you a real, real good deal on them with excellent
financing terms. We would really like to be your sole supplier for this
product. We don't think you really need Ciena (and who knows whether
they will ever be the same after Tellabs?) as a second supplier." That's
pure speculation on my part, that is fictional and I have no proof.
But..... But, @ 10:15am on 8/21/98, 45 minutes before the start of both
Shareholder Meetings at both Tellabs and Ciena, AT&T called and said
they do not plan to deploy Ciena's 40 or 96 channel systems. Wow. What
impeccable timing! What a bizarre coincidence? This represented Material
Information that was not presented in the Proxy and the only Ethical
decision was to postpone both Shareholder Meetings until the Boards and
Shareholders had an opportunity to review the new information. The
meetings were postponed until 9/9/98, but that date can be changed of
course. Imagine the shock of all the Big Institutional Fund Managers
that were gathered at the meeting to cast their votes! Here it is, the
Dow is down 283 points and they are ready for the vote and they hear
that AT&T has suddenly dropped the possibility of a future contract and
the meeting is adjourned. Time to get on your cellphone!
During that market slaughter on Friday, both stocks were halted for
proper dissemination of the news to the General Public. The Dow was
still bleeding, but TLAB and CIEN were halted. Halted is bad. When the
news came out to the public, the BIG ARBS who had VERY LARGE SUMS OF
MONEY committed to the deal going through suddenly dropped a brick in
their pants! The market was getting crushed, they were hyper committed
to what seemed to be the wrong side of the TLAB trade, and no one wanted
to buy anything ahead of the weekend and no one wanted to buy Ciena
ahead of the boards coming out with some news. On top of all that, they
couldn't get unwind their positions since the stocks were halted. This
is what's called a Maalox Moment. When the stocks finally did open,
every ARB immediately tried to unwind his position at whatever price he
could get. This meant buying back TLAB shares and selling CIEN shares or
the option equivalents. Buying TLAB shares wasn't so hard, since the
market was selling off there were many being offered for sale. That
helped them a little though it still rose significantly.
But trying to sell CIEN shares in a bleeding market when everyone
around you is trying to sell their shares and no one is buying ahead of
the weekend was a particularly distressing feat. Suffice it to say that
CIEN dropped over 50% nearly instantly since there weren't enough buyers
around to pick up the slack. I was able to buy a few shares near the
bottom at 27 _. CIEN made some slight comebacks to the 34 level but
returned to the 31 area. There simply was a complete information vacuum
about whether the deal would go through and at what ratio. In a losing
market ahead of the weekend with lots of international problems, there
weren't enough buyers to step in. CIEN closed the day down 45% at about 31. Ciena closed somewhere in the range of where it would trade if there
was no deal and there was no Company A. Probably 25-40 would be that
range depending on various factors. So, now you understand why there was
a 45% drop in CIEN. You also see how gleeful Lucent must have been all
this weekend. I think I can hear the laughter now all the way from
Basking Ridge.
After the bell, a conference call was held with Pat Nettles from Ciena
where he repeated a quote from Mark Twain, "News of our demise is
grossly exaggerated."
Here's a breakdown of what transpired on the CC.
There was no expectation of AT&T revenue in the 1998 period.
Expectation was for 1999 AT&T revenue of about $50M versus $880 total
revenue
The $50M shortfall will be made up by International and CLEC new
customers
We are comfortable with the original $880M Revenue estimate
We won't say we are comfortable with prior 1999 earnings estimates
We have discussed this possibility with Tellabs Mike Birck at great
length before
The Software investment will benefit all of AT&T's competitors
Full disclosure of our current is not required until 9/15/98
Obviously can't comment on any potential change in the Exchange Ratio
We have no plans for a writedown on the AT&T work
Worldcom has given positive indications and we are optimistic for orders
end of 98
AT&T did not yet have a 40 channel system on hand
We have 3 customers running on 40 channel systems
96 channels will be ready in 1H99
Ciena is committed to the deal that has been struck (of course)
We are not entertaining an alternative deal
Independence and Strategic Alliances are always an option
We can't say whether AT&T would buy 96 channels in '99
We don't expect further dilution
We have some New Customer Announcements to make
40 channel and higher will be strong
We are TOTALLY BAFFLED BY THE AT&T DECISION
We are the only product shipping at this density and spent a year on the software
Our sales team has done well, no slip up there
OC192 will be soon, when needed
We can't speculate on the timing of the AT&T call
We won't speculate on Lucent's motives
New Customers will help us to meet street expectations
We've mostly done planning thus far with Tellabs
Customer Satisfaction with 40 channel systems is Phenomenal!
That $25M order has not been awarded yet
9/9/98 allows more than a week to go by and avoids the Labor day holiday
So, we need to hear from the Tellabs Board to see what is going on.
Ultimately, the deal was not hinging on any AT&T revenue, it hinged on
technology. It allowed Tellabs salesforce to sell an integrated package
of Digital Cross Connect and DWDM systems among many other products to
their existing customer base. This prime motivation is still intact.
Understanding the tactics that Lucent may or may not be capable of, it
is now a must for Tellabs to complete the merger to avoid it's own
limitations of size and technology. TLAB/CIEN must go through in order
for them to achieve the synergies necessary to continue. Lucent would
like nothing better than to sink the merger permanently. It's a very
tough world out there. Also, if Tellabs drops the ball, Cisco will
probably come in and pick up Ciena for an attractive price. Mike Birck
knows who Company A is and he was scared enough to build in a $200M
breakup penalty to avoid a Counter Offer. That pressure still remains.
Tellabs will still want to go ahead with this deal, but they may want to
renegotiate the price to appease their own shareholders. I propose that
the appropriate discount is 1 share of Ciena for .85 share of Tellabs.
Much lower than that and Cisco will be free to swoop in with a Counter
Offer. Any higher than .9 shares of Tellabs won't give the TLAB
shareholders that warm fuzzy feeling of getting a discount. So, I
believe the point of least pain lies between .8 and .9 shares of TLAB.
History remembers that British Telecom dropped the price of the MCI bid
by 20% because MCI had some legitimate Expense problems. WorldCom came
in with a higher offer and raised it yet again to fend off GTE and
British Telecom. At some point, your strategic future is worth more than
a few percentage points in either direction. That is clear both to the
TLAB and the CIEN holders.
I'm sure the Tellabs board has been meeting with the Ciena folks and
the Goldman Sachs and Morgan Stanley folks this weekend. Some sort of
amicable resolution will be found and may even be announced as early as
Monday. In the meantime, there are still some ARBS hanging in there that
may choose to bail. Also, in a tough market, and without concrete info
from Tellabs about the deal, it's tough to make the call and wade into
CIEN shares for most people. It comes down to too many factors. I felt
the 27 _ price was just too tempting to pass on. But I did that on sheer
instinct in an information vacuum. After reviewing the Conference Call
from Friday night, I feel confident in Ciena's future going forward as
part of Tellabs.
Lucent, however, is still happy. Even if the deal goes through, even
uncertainty and questions will have been raised in reference to this
deal and the expected dilution and synergies from it that the market
will probably discount shares of TLAB for awhile until actual positive
results start coming in. This means that TLAB will probably not trade in
the 90's again anytime soon and this dilutes the value of their shares
to be potentially used in another transaction (something Lucent wants).
In the meantime, Lucent has it's own acquisitions to make come October
1998 when their pooling restrictions are lifted. The worst kept secret
on the planet is that Ascend is their obvious and favorite target. If
Lucent wants to compete against Cisco in the data networks of the
future, it had better start out with the only company that is
effectively competing and beating Cisco today. Ascend's leadership with
the GX550 is extreme, winning huge deals against Cisco. Ascend is the
Remote Access Concentrator leader in the Carrier market. Ascend is the
Frame Relay market leader. Ascend has the hottest ATM products this
year. Lucent can't wait to develop this stuff in the lab, and small
acquisitions like Livingston and Yurie aren't going to fit the bill.
Lucent would only have to issue about 10% of it's shares to acquire
leadership in almost all categories. That's not a large price to pay.
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