Zhone's Strange Saga

The U.S. Federal Trade Commission has cleared the way for the merger between Zhone Technologies Inc. and Tellium Inc. (Nasdaq: TELM) (see Tellium/Zhone Merger Proceeds).

In the proposed merger, Zhone, a private company, is acquiring Tellium, a public company with a pile of cash, in exchange for Zhone stock, which will make Zhone a public company when the deal closes sometime this fall. Recent public filings by Tellium on the merger give the first public view inside Zhone since it withdrew its IPO registration in 2001.

The filings are startling. Zhone has spent more than $450 million on acquisitions, and it still has less than $100 million in annual revenues to show for it. It's suffered net losses of more than a half a billion dollars in the four years since it was founded -- $193 million in 2000, $243 million in 2001, and $100 million in 2002. In all, the newly filed documents filed with the U.S. Securities and Exchange Commission (SEC) raise questions about how one of the world's best-funded networking startups can be one its most underperforming -- and why Tellium shareholders would agree to be acquired by it. This comes on top of the pay packages guaranteed Tellium executives in the move (see Exec Payoffs Dog Zhone/Tellium Merger).

"It's extremely bizarre," said one Wall Street analyst familiar with both companies, who spoke under condition of anonymity. "Here's a private company that was going to go out of business, and they get 60 percent of a public company that was trading at cash. That's one strange transaction."

It's just one more step in the strange saga of Zhone.

Zhone was founded in 1999 by CEO Mory Ejabat and CTO Jeanette Symons, who hailed from the same posts at the legendary Ascend Communications, which was one of Wall Street's biggest rockets in the early-to-mid nineties, until it was acquired by Lucent Technologies Inc. (NYSE: LU) in 1999 for the astounding sum of $24 billion. Zhone started out with $500 million in funding from a range of investors, most of it in the form of leveraged buyout (LBO) money. More money was borrowed over time, as Zhone made acquisitions totaling more than $450 million.

In October of 2000, Zhone filed for an IPO (see Zhone Files for IPO), but by then the telecom bubble had popped, and the IPO window slammed shut (see Zhone Zhaps IPO ).

Three years later, the company is still losing money. For the six months ended June 30, 2003, net revenues were just $37.6 million, down roughly 40 percent from $60.6 million in same period of 2002. That represents less than $20 million per quarter for 2003. Net losses for the six months ended June 30, 2003, were $5.6 million, compared with $27.8 million for the same period last year.

Zhone's got debt, too: On a recent conference call with Wall Street analysts, execs said the company has been borrowing on a $25 million credit facility from Silicon Valley Bank, of which $10 million is already used up. For the quarter ended June 30, 2003, Zhone reported an additional $36 million in long-term debt.

Where's the money gone? It's a far cry from Zhone's early promise to become a heavy hitter by selling a supreme telecommunications god box (see Zhone Details Product Strategy)

The money doesn't appear to have gone into products. Of the eight companies Zhone spent $450 million to acquire, at least three -- CAG Technologies, OptoPhone, and Xybridge -- have been written off and their technologies discontinued, according to SEC filings. There may be other missing acquisitions: It's not clear exactly how the rest of the companies Zhone has bought have factored into its current product lineup.

Table 1: Zhone Acquisitions, 1999 - Present

Company acquired	Date	Transaction value
NEC Eluminant	Jan-03	$13.6 million
Vpacket	Jul-02	$19.2 million
Nortel AccessNode and Universal Edge products	Aug-01	$37.7 million
Xybridge	Feb-01	$72.7 million
OptoPhone	Feb-00	$2.2 million
Roundview	Feb-00	$.3 million
CAG Technologies	Nov-99	$8.8 million
Premisys	Oct-99	$295.8 million
Total		$450.3 million
Source: SEC Filings

Zhone's not putting much into R&D, either: For 2002, it spent $29.8 million; for the first six months of 2003, $10.26 million.

There's personnel, but that's no show-stopper. Salaries aren't particularly high: Ejabat and Symons earn a modest $350,000 and $250,000 annually, and there are no bonuses. Of course, the company has ten directors and officers, more than companies twice its size. And recently there have been large bouts of layoffs.

There are those fancy digs in Oakland, Calif.: In 2001, Zhone shelled out $52.7 million for its three-building headquarters. In addition, Zhone leases more than seven other offices and R&D facilities worldwide. All this for a company that never had more than 500 employees -- and now has 240. (With the addition of Tellium employees, that total will rise to 417.)

Zhone vice president of marketing David Markowitz said that the company is still on track with its strategy -- to expand the company through acquisitions and develop new products. "The responsibility we have is to grow this and get to profitability," said Markowitz.

Markowitz says most of Zhone's comments on the merger could be seen in the Tellium filings with the SEC. "Right now, our priority is to get this thing done; later we can say more."

One explanation of the mismatch between Zhone's output and input is that the numbers are deceiving. For one thing, the $500 million in early funding came largely in the form of leveraged buyout money -- which is only disbursed when buyouts are made. That's different from venture capital, which comes in the form of cash that can sit in a company's bank account.

However much money Zhone did have at one time, there's little money on the balance sheet today. For the six months ending June 30, Zhone held only $1.9M in cash, according to SEC filings. That's down from the $77M in cash it held in December 1999. At the rate Zhone's been losing money, that means it would have run out of cash within a quarter or two -- which may have forced it to hatch the plan to acquire Tellium. Tellium still has $150M in cash on its balance sheet.

Figuring out the how and why of these finances is complicated, but the bottom line remains clear: Zhone has spent $450 million on acquisitions, but it's still bringing in less than $100 million per year in revenue, and it's still losing money. It's buying Tellium to acquire some cash to keep things going.

You would think that all this might have Tellium shareholders scratching their heads. But so far there's been little outcry, and it looks like the deal is likely to go through.

Tellium officials were not available for comment.

— Mary Jander, Senior Editor, and R. Scott Raynovich, US Editor, Light Reading
http://www.lightreading.com

(Editor's note: This article is one in a multi-part series on the merger between Tellium and Zhone. Read the previous story here: Exec Payoffs Dog Zhone/Tellium Merger.)