It appears Marlin Equity Partners, a private equity firm, is attempting to create a new Optical Systems roll-up company. Specifically, the company announced today that it was acquiring the Optical Systems business of Nokia Siemens Networks (NSN). This follows the announcement in October of the acquisition of optical switching company Sycamore Networks. Marlin is quoted in the press as saying it wants to act as a consolidator in the optical market and buy more assets. Thus, it is likely they will look to acquire more optical in assets in the future.
Strategy Will Be Challenging
My take on this strategy is that a successful outcome will be difficult for Marlin. While the long-term historical growth rate in the optical systems industry is fairly robust at 6%-7%, actual annual growth rates are very volatile around the average. In addition, gross margins in the optical systems market have remained in the 35%-45% range for over 20 years with high R&D costs required to maintain innovation limiting overall net profit margins. This has led to very few optical systems companies showing consistent profitability and free cash flow generation over time. Finally, Marlin will only have a combined global market share of about 4% with NSN and Sycamore. With Chinese competitors Huawei and ZTE of both having materially higher share of about 20% and 12% respectively and technology leaders Alcatel-Lucent and Ciena having shares of about 16% and 10% respectively, Marlin will be very challenged to obtain scale in the business.
Buying Cheap, But May Not Be Enough
The one advantage Marlin has in its strategy is that it is implementing this roll-up strategy at a time when optical system valuations are at the low end of the historical range in terms of price/sales multiples (e.g. Ciena is trading at about 0.8x sales vs. a 5 year range of 0.5x-3.5x) and my guess is they are not paying much for either NSN or Sycamore. However, compiling 2nd/3rd tier businesses at low prices does not guarantee a great strategy. I have yet to see a successful roll-up strategy of 2nd/3rd tier players in the communications equipment market (e.g. Zhone). Marlin will also perhaps be challenged in quickly achieving cost reduction given a high level of European employees in the NSN transaction. I am sure Marlin was aware of this prior to pursuing the deal, but even so, layoffs in Europe typically take a long time to implement and have high severance costs associated with them. Look at all the issues Alcatel-Lucent is having in cutting headcount in Europe even as the company is burning cash consistently and has a troubled balance sheet.
Sign of the Times
We have also seen some recent attempts at buying assets on the cheap as part of rollup strategy this year in the sector including Adtran/NSN in the broadband access market, Calix/Ericsson in the broadband access market and Oclaro/Opnext in the optical components market. Thus, Marlin is not alone in trying to take advantage of companies “throwing in the towel” in certain businesses and buying assets at low prices in an attempt to build scale and value over time. I suspect this trend will continue given the ongoing slow capital spending growth in the sector and poor stock performance of equipment manufactures. Companies like Alcatel-Lucent and Tellabs have already announced plans for layoffs, and closing/selling certain businesses within these and other companies over time is likely in my view
Adva or Fujitsu USA May Make A Good Fit For Marlin
For years as an equity research analyst there was constant speculation about private equity and other companies looking at rolling up the 2nd tier optical systems companies. When Nortel’s optical systems business went up for sale in 2009 during the Nortel bankruptcy process, however, only Ciena and NSN (likely partnered with private equity at the time) actually bid on the assets. The fact that no other private equity shop bid on the Nortel asset at the time and the lack of any other attempt to rollup the optical system industry since then I think is a sign that the actual implementation of such a strategy will be challenging.
Given that Marlin now appears ready to give the optical systems rollup strategy a shot, what other deals might be appealing to them? NSN is strongest in long haul transport and Sycamore has technology in bandwidth management/switching. Thus a metro optical company would make the most sense for Marlin. The two that come to mind here are Adva and Fujitsu’s US optical business.. Fujitsu is already partnered with NSN in the US market at AT&T. The challenge with acquiring the Fujitsu US optical business is that the R&D is done in Japan, which will complicate the integration of both NSN and Fujitsu. Adva might be an easier integration given that the company is based in Europe, where most of the NSN R&D is centered. It certainly will be interesting to watch….