Marlin Attempts A Roll-Up Strategy In the Optical Market – Good Luck!

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….

Will Cable TV Stocks Continue to Outperform Post the AT&T Analyst Day?

Well hurricane Sandy continues to pound my neighborhood and while my standby gas generator continues to keep the lights on, a large tree just fell in front of my house.  Check out the picture below. Luckily, no one is hurt.  So with everyone safe and not much else to do, I wanted to share my thoughts on whether or not the upcoming AT&T analyst day will impact the future stock performance of Cable TV operators and AT&T broadband access equipment suppliers like Adtran, Alcatel-Lucent and Ciena.

Hurricane Sandy Hits Home

Sometimes, the performance of a stock or industry can be determined by a significant change in the competitive landscape. The performance of leading Cable TV stocks Comcast and Time Warner Cable over the past several months I believe is a case in point.  Since December 1st, 2011 Comcast and Time Warner Cable stock prices are up over 60% while the S&P 500 has only gained about 13% over the same period.   What happened to the competitive landscape after December 1st 2011 that led to such a strong outperformance of the Cable TV stocks?  Simple, Verizon announced it was purchasing the wireless spectrum owned by Comcast, Time Warner Cable and Bright House on December 2nd, 2011.  In addition, both AT&T and Verizon in 2012 have reduced their respective spending on their wireline networks as they dramatically shifted their capital spending and strategic business development towards the expansion of their respective wireless businesses.   Basically, Cable TV operators kept focusing on what they do well, namely, residential triple play while AT&T and Verizon were both in a hunt for obtaining spectrum in a manner acceptable to the FCC/DOJ and in a race to see who can build out a 4G LTE network the fastest.

The question now becomes, will this favorable competitive dynamic continue into 2013.  I think we will get part of the answer to this question at the upcoming AT&T analyst day scheduled for November 7th.  The press and analyst community has written about how AT&T is contemplating upgrading millions of rural access lines with higher speed broadband technology.  A decision is likely made public during this analyst meeting.  In addition, industry people have suggested that AT&T may be also considering a more comprehensive broadband initiative for 2013 that will also target the small medium business market to fend off an increasing effort by the Cable TV operators in this segment of the market.

A renewed focus by AT&T on rural broadband and being more aggressive against Cable in the SMB segment, could cause a shift in the favorable competitive dynamics Cable has seen since December of 2011. This could put some pause, at least temporarily, in the strong outperformance of the Cable TV stocks.  Also, if AT&T was to indicate a new rural broadband spending plan and more spending to fend off Cable in the SMB market for 2013, it could cause a bounce in the Broadband Access and Metro Ethernet equipment suppliers that supply to AT&T such as Adtran, Alcatel-Lucent and Ciena.