Rough Week for AFC

Opinions are like FTTP RFPs: Everybody seems to have one. But the opinions appear to be especially strong when it comes down to the ongoing soap opera involving Advanced Fibre Communications Inc. (AFC) (Nasdaq: AFCI), Tellabs Inc. (Nasdaq: TLAB; Frankfurt: BTLA), and Verizon Communications Inc. (NYSE: VZ).

This week all sorts of speculation emerged as to whether AFC's difficulties in deploying its FTTP (fiber-to-the-premises) equipment for Verizon's big FTTP rollout could jeopardize its pending merger deal with Tellabs.

Early in the week, analyst research reports put pressure on AFC shares. Then the rumor mill fired up with reports of the FTTP rollout going poorly. And now, Verizon has confirmed it will add a second source to its FTTP project in 2005.

"It's crazy -- there are all sorts of rumors out there driving AFC down," says a hedge-fund manager who spoke on the condition of anonymity [ed. note: we'll call him "Raimundo"]. He owned AFC stock on the premise that the deal with Tellabs would be approved, but noted he'd "already lost a lot of money" on AFC's decline.

AFC’s stock on Friday was trading at $14.90, down 9 percent for the week and 12 percent below the proposed merger price with Tellabs of $16.60. When a merger deal is pending, the difference between the merger price and the acquiree's share price usually shrinks as the deal nears completion, a sign of confidence the deal can get done. The widening spread between the deal price and AFC's stock indicates significant skepticism that the deal will go through.

"AFC is really in big trouble," says Ravi Bhagavan, managing partner with The Merton Group LLC, a broadband service provider based in Florham Park, N.J. "They have not been able to satisfy some of the preliminary standards [at Verizon]. Verizon is looking at penalizing them or potentially moving to a different vendor."

Sources close to the carrier say there continue to be a number of technical problems with the rollout of AFC's FTTP platform, which includes a combination of its AccessMax Digital Loop Carrier and a new Optical Line Terminal (OLT) card, which gives it passive optical networking (PON) capabilities. In addition, the sources say there is growing interest in Verizon using Motorola Inc.'s (NYSE: MOT) PON product (gotten with its acquisition of Quantum Bridge) to fill in parts of its FTTP network. Whether this would entirely replace AFC product or just become a second source isn’t clear.

AFC has been plagued with delays in the rollout of its equipment for Verizon's FTTP projects, and it incurred at least $3 million in fines from Verizon for missing deadlines (see Tellabs Calm Over AFC Hiccup and AFC Fesses Up, Defenders Pipe Up).

Meanwhile, the plot thickens, as Verizon says it's definitely going to add a second source for the project. "Because of the size and scope of the project, we plan to add another provider in 2005," says Verizon spokesman Mark Marchand. He adds that Verizon "continues to work with AFC" and notes that past problems, including AFC's missed deadline and fine, have been disclosed by both companies. AFC did not return calls at press time. A Tellabs spokeswoman says her company isn't worried: "We still are looking to close the deal."

All and all, the speculation and negative chatter have concluded a rough week for AFC.

A negative research note issued by Lehman Brothers' Steven Levy earlier in the week could have started the ball (well, AFC's stock) rolling downhill. In that note, Levy told investors to avoid the stock. He also said there are indications that AFC's business prospects are weakening.

“We believe that the company’s core business has likely continued to weaken and while its outlook for fiber-to-the-premise (FTTP) equipment sales to Verizon appears to have improved some, the mix of FTTP products has shifted more towards the unprofitable Optical Network Terminal (ONT) segment and away from the profitable, central office-based, Optical Line Terminal (OLT),” wrote Levy.

Levy lowered his 2004 and 2005 revenue and earnings estimates. He now expects $461 million in revenue and $0.18 in per-share earnings for 2004 and $523 million in revenue and $0.20 per share in profit in 2005. He also lowered his price target to $15.25 from $27.

Other analysts were jumping on the bash-AFC bandwagon. In a research note on Tellabs titled "TLAB; Buyer’s Remorse Awaits?", Jeffries & Co. analyst George Notter noted that sources were citing continuing technical problems with AFC’s FTTP deployment at Verizon, but he didn’t believe it would end up killing the deal with Tellabs.

”Our contacts at Verizon indicate that AFC is still working to alleviate a number of performance issues on both the OLT and ONT platforms -- at this point, none of these issues appear to be showstoppers,” wrote Notter.

Notter also wrote that Verizon has started to shift in its affections for PON. While at one time it was committed to broadband PON (BPON), Notter said Verizon is now increasingly interested in Gigabit PON, because it can provide higher levels of bandwidth that would be more compatible with delivering HDTV. Notter noted that the new GPON standard allows for downstream transmission rates of 1.25 Gbit/s or 2.5 Gbit/s (versus 622 Mbit/s for BPON).

— R. Scott Raynovich, US Editor, Light Reading