Did Nortel Play JDS for a Fool?

Mar 01 2001

Not all that long ago, JDS Uniphase was a Wall Street darling, riding the once-soaring demand for optical-networking components. Its stock, which peaked last spring at about $150 a share, seemed on the verge of being the next Cisco Systems , and the company had a market cap well north of $100 billion. Last month, JDS took a step toward consolidating its hold on the market by completing its long-pending acquisition of its biggest rival, SDL . It should have been a time for JDS investors to celebrate. Instead, they've been bailing out.

In fact, since the close of the SDL deal, JDS shares have lost about two-thirds of their value. Now trading at about $27 a share, the stock has been hovering near a 52-week low. The company has twice lowered its guidance on future earnings, and this week it announced plans to lay off 3,000 employees, or about 10 percent of its staff.

The company also finds itself in a messy debate over the terms of its agreement to sell a Zurich-based facility that makes 980-nanometer pump lasers, a key component in optical networks. Federal regulators required the sale of the plant as a condition for approval of the SDL acquisition. JDS agreed to sell the plant to Nortel Networks for $3 billion in Nortel stock.

Or at least, the stock it received used to be worth $3 billion. Nortel's stock has been in freefall in recent weeks, because of its own earnings woes. The Nortel shares JDS received in the deal are now worth just $1.2 billion. Mark Langley, a senior telecom analyst for Epoch Partners, says the lowball value of the plant is about $3 billion. Ergo, it seems JDS Uniphase sold a plant that controls 40 percent of the market for a very valuable type of laser at a huge discount.

Given that the close of the JDS plant sale to Nortel came just weeks before Nortel issued a shocking earnings warning that sent its stock reeling, one might wonder if JDS Uniphase management is considering litigation or some other remedy. But JDS says that it is not going to sue Nortel over this, and that it will try instead to negotiate a solution. One reason for its careful stance: Nortel is JDS Uniphase's biggest customer, responsible for at least 10 percent of JDS Uniphase's revenues.

Both companies are downplaying the situation.

"The deal is closed, and no one was jerked around," a spokesman for Nortel says.

"We are trying to get over it and move on," says a representative for JDS Uniphase.

Clearly, though, the two parties need to rebuild their relationship. "JDS Uniphase's shareholders are frustrated about the deal, but it's important for the companies to work hard to get things straightened out," says Max Schueltz, an analyst at Thomas Weisel Partners.

The key question is whether Nortel withheld information from JDS about its deteriorating financial position. Rivals Cisco and Lucent Technologies had previously disclosed earnings issues, but Nortel CEO John Roth repeatedly reassured investors that everything at his company was on track. Then on Feb. 16, Nortel said earnings this year would fall far short of expectations. Nortel shares crumbled by a third on that day alone, and have been limping ever since.

Some shareholders wonder if Nortel withheld information in an effort to get the plant from JDS at a bargain price. Some analysts give Nortel the benefit of the doubt: "I don't think they behaved unethically," says Tom Astle, an analyst at Merrill Lynch . "Roth was probably telling everyone it was OK because that is what he thought," adds Schueltz.

Schueltz has another theory on the mishap. Both Nortel and Lucent are spinoffs of larger, older companies, he observes. The companies have many legacy processes that are slow and inefficient. Whereas newer companies such as Cisco are famous for closing their books within hours after a quarter ends, Nortel is much more out of touch with how things are going. "The movement of information is very slow in Nortel and Lucent," says Schueltz. "Now Nortel will move aggressively to correct this."

But there may be other trouble ahead. Seth Spalding, an analyst at Epoch Partners, says Nortel remains too bullish about the rest of its year. Astle says he likewise does not think Nortel can meet the 15 percent revenue growth it is predicting for this year. And that also means more trouble ahead for JDS, which now finds itself not just a major supplier to Nortel but a major shareholder as well.