Hitting the optical nerve: M&A, IPOs drive company valuations

Thinking of buying an optical networking equipment company? Or selling one? Marketwise, the timing couldn't be more perfect. The astronomical prices being paid by the likes of Cisco Systems and Nortel Networks for cash-burning start-ups and the IPO jackpots of the Sycamore Networks variety have blasted the roof off optical players' valuations.

What's more, few acquirers or analysts wax pessimistic about the past four months' balance sheet busters and multibillion-dollar stock deals. Is everyone inhaling a little too deeply or are intelligent optical networks really a "next big thing?"

The experts justify the valuations by pointing to the tidal wave of data traffic volume coming at voice networks and say optical technology is the only answer to carriers' network capacity issues.

"Having to deal with that massive influx of data gives an opening to all kinds of [optical] start-ups - on the switching side, the transport side, in the core, in the access, you name it," said Dana Cooperson, director of optical networking at RHK.

But it's not as simple as big pipes and big pumps. Highfliers such as Cerent (acquired by Cisco for $7 billion), Qtera (bought by Nortel for $3.5 billion), and Siara Systems (acquired by Redback Networks for $4.3 billion) promise to add intelligence at the service layer, eliminating manual provisioning and administration.

"All have strong software offerings and strong management and intelligence characteristics in their platform, in addition to offering spectacular bandwidth," said Max Schuetz, vice president of research at Thomas Weisel Partners.

When will the "massive" spending cycle foreseen by optical executives and analysts begin? Forecasts vary widely. Estimates for 1999 spending on optical equipment worldwide fall between $9 billion and $11 billion - a small percentage of total communications equipment outlays. Compound annual growth will reach at least 20% to 30%. The worldwide market could be as large as $41 billion by 2003, Cooperson said.

But clearly other factors are driving optical company valuations. Primary among them is the urgency with which Cisco, no stranger to acquisitions, has spent its expensive stock to become a top-tier telecom equipment supplier. It hopes to tie together its Cerent, Monterey Networks and Pirelli purchases, throw in its high-speed terabit routers and build next generation IP transport networks.

Despite paying the equivalent of $25 million for each Cerent employee and $3.8 million for each Monterey employee, Cisco believes it got good deals. By the time the Cerent acquisition was completed, the company had 200 paying customers, said Carl Russo, former president and CEO of Cerent and now vice president and general manager of Cisco's optical group. And Monterey's price was cheap when compared with the $20 billion-plus market cap that the public market awarded competitor Sycamore. That makes Cisco's optical buying spree fundamentally different from that of competitors, Russo said.

It's too late, however, for Cisco to lower the bar it has raised. Its smaller competitors actually seem to welcome the high valuations. For example, Redback said its addressable market for 2001 went from $2 billion to $20 billion with its $4.3 billion takeover of Siara, which has yet to sell a product. Redback could not have completed such a sizeable deal if its own stock had not been so richly valued.

"While these valuations are difficult to understand, they allow small companies like Redback to compete against the giants," said Craig Gentner, chief financial officer of Redback.

Analysts expect M&A activity to blaze unabated. "After the initial product thrust, it may be better [for start-ups] to be acquired to be part of a larger company's product offering. That presents a more compelling sales proposition to large carriers," said Eric Young, a board member at Optical Networks and a general partner at venture capital firm Canaan Partners.

As investors thirst for broadband infrastructure stocks and equipment giants seek to expand their optical offerings, start-ups are forming quickly, attracting bucketloads of venture capital. Corvis, the latest example, garnered $215 million in a recent financing round that valued the company at more than $2 billion. Besides Optical Networks, the next companies likely to attract hordes of public and private investors include Cyras Systems, Kestrel Solutions, Astral Point and Quantum Bridge. Astral Point and Quantum Bridge offer a method of partitioning optical access pipes into T-1, Ethernet, frame relay and other services.

Of course, entering optical networking was not the science project it was when Lucent Technologies, Nortel and Ciena pioneered it. A lively components market built by the likes of JDS Uniphase - itself richly valued - means equipment start-ups can focus on their core networking expertise instead of building piece parts such as Sonet multiplexing application specific integrated circuits, wave division multiplexer filters, optical amplifiers and specialized lasers and receivers.

Still, these well-funded independents and acquired units have much to prove and could hit a dead zone in the customer adoption cycle. New generation carriers such as Williams Communications and Iaxis are testing and buying now, while RBOCs and other incumbents bide their time. "People are still discounting these companies because, though the opportunity is big, carriers still aren't deploying this stuff en masse," Schuetz said. "Once the incumbents start [buying], the dollar volumes are going to skyrocket."