BTAB on XYLN/ALA
HIGHLIGHTS:
-- Alcatel plans to offer $37 in cash for each Xylan share for a total
purchase price of approximately $1.8 billion.
-- Alcatel's Management expects the deal to be accretive in 2000 before
goodwill charges, based on an aggressive revenue objective. In our
view, these assumptions could be overly optimistic.
-- The acquisition could boost Xylan's service provider sales efforts,
and better positions the combined entity to offer integrated voice and
data solutions.
DETAILS:
Alcatel announced a definite agreement to acquire Xylan for $37 per share
in an all-cash tender offer. The tender offer is scheduled to commence on
March 8, and last for 20 days. The acquisition is expected to close in
April. At $37 per share, the total value of the transaction would be
roughly $1.8 billion. The offering price represents a 29x multiple to our
2000 EPS estimate of $1.26. This multiple is less than some other high-
profile data communications acquisitions, however, most previous
combinations have been stock purchases or pooling. In addition, we believe
the multiple reflects Xylan's revenue linearity or general lack thereof.
The company's quarters tend to be back-end loaded, with 55% or more of
total sales closed in the last month of the quarter. Although Xylan has
been successful in meeting or exceeding Street expectations, the uneven
linearity reduces forward visibility and makes forecasting more difficult.
The acquisition is the culmination of a long-standing partnership between
the two companies. Alcatel has been an OEM customer of Xylan since 1995,
but became a significant revenue contributor only in the last two years,
representing 12% and 16% of 1997 and 1998 revenue, respectively. From a
strategic perspective, we believe the acquisition makes sense for both
parties. Xylan's enterprise customer base has been moving steadily toward
fewer strategic networking providers that can offer end-to-end network
solutions. To its credit, Xylan has been able to compete against broader
product lines from larger market forces, such as Cisco and Nortel/Bay,
because its products are technically superior in many respects appealing to
the high-end enterprise customers. Part of the rationale behind the
acquisition is to combine Alcatel's voice expertise in the PBX arena with
Xylan's data focus into a more comprehensive, integrated offering.
Moreover, in 1998, Xylan began to focus more intensely on service provider
customers. Service providers accounted for 16% of total revenue in 1998,
and the Company's 1999 goal was to double service provider sales.
Nonetheless, Alcatel's service provider presence is much stronger than
Xylan's, in our view, and combining forces is likely to be more beneficial
than trying to go it alone. Indeed, Xylan had been working with Nortel on
carrier opportunities, but that relationship was not living up to
expectations, in our estimation, at least in part due to the Nortel's
acquisition of Bay Networks, one of Xylan's principal competitors.
While we believe the acquisition is fundamentally compelling, there are
several issues and concerns we would highlight to investors.
-- Most importantly, we believe the revenue assumptions to make the deal
accretive to earnings in 2000 are overly aggressive. Alcatel believes
sales channel synergies can drive close to $1 billion in Xylan revenue
in 2000, and increase the Company's worldwide market share in LAN
switching to 10%. In our view, these projections may prove extremely
optimistic. By our estimates, Xylan only holds about 2% of the LAN
switching market, and our 2000 revenue estimate is $590 million. We
believe increasing Xylan's revenue by another 66% to $1 billion would
be a Herculean feat.
-- Employee retention is always an issue in large technology
acquisitions. Xylan's employees have been extremely loyal to the
Company, attracted by the Company's entrepreneurial spirit and
underdog-like mentality. We expect the Company's engineers (some 300
strong) are likely to receive significant attention from Silicon
Valley start-ups with attractive equity offerings.
-- There may be some concerns regarding product overlap with the products
gained from Alcatel's recent purchase of Packet Engines. We believe
Management was quite clear in positioning the Xylan products, namely
the Omni S/R as a wiring closet platform, with the higher capacity,
more expensive Packet Engines switch serving as a campus/enterprise
backbone device. However, Alcatel will have to work to seamlessly
integrate the two product lines, in our view.
-- The impact of the acquisition on existing customer relationships is
also an issue. IBM is Xylan's other major OEM partner, accounting for
17% of 1998 revenue, although IBM's contribution has been declining
over the past 9-12 months. We do not foresee a major problem in this
partnership, and would expect IBM to continue its OEM relationship
with Alcatel, post-acquisition. We do not believe Nortel is likely to
continue working with Alcatel, given the competitive nature of the two
companies, but Nortel was not a significant revenue source for Xylan.
For Alcatel, the most important relationship is with Cisco, where the
two companies are becoming more competitive in the enterprise market
as Alcatel brings more products in-house. We believe there is a
possibility that the two companies could work cooperatively on certain
WAN and service provider projects, but overall the relationship is
likely to become more strained.
In conclusion, we view this acquisition as positive for Xylan as the lack
of a "big brother" was increasingly disconcerting given customer trends
toward large, broad-line suppliers, continued market consolidation, and
increased emphasis on service provider opportunities. Alcatel, in our
view, provides Xylan with a stable, global platform for product development
and potentially an overall stronger competitive position.
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