Signs of Life in Tech Mergers

How do you value a company that has no revenues and no publicly-known customers?
Joseph RadiganDecember 21, 2000

On the morning of Dec. 19, Ciena Corp. said it would buy privately held networking company Cyras Systems for $2.6 billion. It didn’t take long for the markets to register their displeasure. In Tuesday’s trading, the stock lost $23 dropping to $73.19. By the close of Wednesday’s markets, Ciena was off another $9.38 and closed at $63.94.

In the first half hour of Thursday’s trading session, Ciena’s shares gained $2.50.

The transaction uses the purchase method of accounting and is expected to close in the first quarter of 2001. Ciena is acquiring Cyras in exchange for 27 million shares of common stock, and is assuming $150 million in Cyras’s debt.

Clearly, the markets didn’t like the deal. But this has been a rotten week on Wall Street, and tech stocks, as bloodied as they’ve been most of the year, suffered some of their worst abuse in recent memory toward week’s end. Fiber optic firms, like Ciena, survived much of the past several months without getting trashed like other corners of the tech sector. This week, however, they weren’t spared.

Perhaps shareholders weren’t happy with Ciena’s projection that the deal will reduce the $0.70 per share earnings forecasted for the October 2001 fiscal year by $0.19 to $0.22 per share, excluding one-time charges and goodwill. They obviously weren’t mollified by the company’s forecast that the deal will be accretive to earnings starting in 2002.

Despite all the blood being spilled on Wall Street, Ciena’s bid for Cyras at least demonstrates that there’s still a market for high-profile mergers. It’s just that Wall Street isn’t happy when such a deal causes sticker shock.

That said, some analysts and fund managers say the deal makes strategic sense for Ciena. While Ciena wasn’t being backed into a corner if it failed to buy Cyras, the target firm is adding some potentially lucrative networking products to Ciena’s portfolio.

Ciena’s strong suit is networking products for long-distance fiber-optic networks, while Cyras’ products are designed for the metropolitan networks at the end of the long- distance networks. The deal will actually heighten the growing competition between Ciena and Cisco Systems, which bought Cerent for $6.7 billion a year ago to move into the same sector Ciena is now entering.

Ciena has been re-selling products from Cisco’s Cerent division to telecom customers who needed metropolitan and local networking equipment in their long-distance networks.

“They could have continued doing that, but they were leaving money on the table,” says Steve Levy, an analyst with Lehman Brothers.

“Ciena did a very smart thing,” adds Steve Humphrey, manager of the Lord Abbett Large Cap Growth Fund. “They bought a company that put them out there in the cutting edge. I think the market overreacted here.”

Again, though, the key question is, “Did Ciena pay too much?” That’s a tough one to nail down. Typically, tech mergers will be valued on a number of factors, starting with a present value analysis of future cash flow.

But Cyras has no revenue, just four beta customers, three of whom are said to be top- tier telecom customers, although Ciena has not publicly identified them.

But the lack of revenue is not taken as a sign that Cyras is an unproven, high-tech start-up. Rather, it is an early stage company in what is generally agreed to be a high-growth segment of the market for networking equipment- -although the estimates as to exactly how large the market will be are all over the map.

Humphrey predicts that the market for metro- area fiber-optic equipment will be $5 billion in 2004. But other research says the market could grow to $10 billion by 2003.

However large the actual number turns out to be, the potential is huge, and Cisco’s 1999 purchase of Cerent is seen as one yardstick for valuing the Cyras deal. Like Cyras now, Cerent had no revenue at the time of the transaction. But it is estimated that the current quarter’s revenue will contribute $700 million to Cisco’s top line, according to Paul Silverstein, an analyst with the brokerage firm, Robertson Stephens.

“We’ve seen Cerent become a leading indicator of how big an opportunity that market is and how quickly that opportunity is materializing,” Silverstein says. “There’s not a lot of technology risk with Ciena buying Cyras.”

Another yardstick being used to measure networking deals is the 1999 acquisition of Siara Systems by Redback Networks for $4.3 billion. That deal closed around the same time that Cisco bought Cerent. Ironically, all three target firms – – Cerent, Siara, and Cyras – – were spun off in the mid-1990s from the same Petaluma, Calif. company, Fiberlane, and their products all use the same language.

But market conditions were much healthier a year ago, and higher prices could be more easily justified then.

Silverstein says, “When Cisco bought Cerent, we were in an environment where it was easier to stomach the price.”

This year, the telecom companies are scaling back their capital expansion plans, and that may force a scaling back of the growth forecasts for companies like Cisco, Redback and Ciena. The slower growth prospects may help explain why Cisco’s purchase of Cyras is valued for barely 40% of Cisco’s purchase of Cerent.

But once Ciena’s management made the choice that it wanted Cyras, it probably didn’t have much choice but to reach deep into its pockets. Reportedly there were two other bidders, so Cyras was negotiating from a position of some strength. That said, Cyras had originally planned to do an initial public offering by the end of the year. Market conditions scotched those plans, and the firm was obviously going to need additional funding if it was going to continue developing its products.

After all is said in done, Ciena’s decision may have simply come down to its management’s survival instinct.

John Rutledge, manager of the Evergreen Technology Fund, says, “There are only going to be a few companies in the optical networking space. There’s no such thing as standing still.” Companies are either making progress or losing market share to their rivals, he adds.

In the early 1990s, there were as many as half a dozen legitimate rivals to Cisco. By the end of the decade, most of them had fallen by the wayside. What’s more, the current trials of Lucent Technologies serve as a vivid example of how far a company can fall if it misses a technology cycle.

In the end, Ciena was determined not to be left out. Perhaps the $2.6 billion price was a bargain.

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