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Author: stocksure Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 5026  
Subject: Re: Like this Deal? Date: 7/24/2000 3:43 PM
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I wouldn't be too worried about the component shortage issue. If the deal goes through, Nortel will own more than half of Corning, which means that it'll be very likely that John Roth will become the new company's chairman, and that a couple of other Nortel execs. will join him on Corning's board of directors. This should guarantee that Nortel gets first dibs on any components that Corning will make.

The primary benefit of this deal is the elimination of channel conflict. I can't help remembering how Lucent's bottom line got boosted after AT&T decided to spin them off, or how Conexant's sales took off once it got unleashed from Rockwell. For whatever reasons, companies really dislike the thought of buying products from their competitors, even if buying these them will allow the given company to create a more competitive offering. So that $1 billion annual revenue figure could be a little misleading, and could rise very quickly as Lucent, Cisco, Alcatel, etc. get more comfortable about buying from this division.

A couple of problems do linger, however. The first is the gross margin issue. It doesn't take a genius to realize that a large percentage of the products created by Nortel's optical components division must be going into the company's own DWDM, amplifier, add/drop, and cross-connect systems. If Nortel decides to sell this division, it'll cost them extra to buy these products from Corning, affecting the margins they receive on the sale of their systems along the way. Granted, since they'll own 60% or so of Corning, a large percentage of these lost profits will indirectly be coming right back to them. But 40% will end up going to the other shareholders of Corning.

Another worrisome issue is the potential dilution of some of Nortel's competitive advantages should all of its bleeding-edge components be available for sale to its competitors. For example, at OFC-2000, they demoed an 80 gb/s modulator/receiver setup. To the best of my knowledge, no one else is able to rival that number for the time being. While it definitely takes much more than the production of optical components that work at a specific speed or channel count in order to create a full-fledged system that works at a given speed/channel count (just ask Lucent), having such products available does help things out a lot. Perhaps Nortel will create an arrangement where they'll have the right to keep Corning from selling certain components to anyone but them, or perhaps Nortel will retain certain parts of this division for themselves. Regardless of what happens, it'll be interesting to see how this dilemma's handled.

It's interesting to see that Nortel isn't considering an outright spinoff for this division a la Lucent Microelectronics, but is rather mulling selling it off to another company altogether. My guess is that this decision was made entirely thanks to the ever-increasing clout of JDS Uniphase. During the SDL merger conference call, a number of comments were made regarding how JDS Uniphase's highly diverse product line of both active (lasers, modulators, etc.) and passive (DWDM chips, isolators, gratings) would allow it to work on creating integrated "systems on a chip" for amplifiers, DWDM transmission systems, and so on.

If JDS Uniphase was able to make such devices, it would allow them to attain huge cost advantages when compared to the competition, and leave Nortel, along with everyone else in the industry, highly dependent on them...unless someone else can do the same thing. Thus the idea of merging Nortel's components division, which possesses active components such as cutting-edge modulators, source lasers, receivers, and tunable lasers, with Corning, which has some very competitive passive component offerings in the add/drop filter and DWDM chip arena. Of course, fi this deal goes through, virtually all the antitrust scrutiny surrounding the JDS Uniphase/SDL deal will quickly go away.

All in all, provided that Nortel can somehow limit the sale of certain products that its optical components division produces to its competitors, this should be a good deal for them, assuming that it goes through. Combined with the fact that they're most likely going to come out with blowout earnings on 40%+ revenue growth, and that the stock is trading at lower multiples than Cisco, whose growth it should be able to equal over the next few years, Nortel could be in for a nice short-term move, provided market conditions hold up.

Since I prefer to invest in companies that I can expect 60%+ earnings growth out of for the long-term, I've so far held off on investing in Nortel. But given the rate at which their optical networking revenues are increasing as a percentage of the company's sales, and the amount of value that could be unlocked by means of the Corning deal (assuming the safeguards that I mentioned are put into place), I'm beginning to think about taking the plunge.

Eric
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