Optical/IP Networks

Component Spinoffs: Dynamite or Duds?

This week, Alcatel SA (NYSE: ALA) will launch an "investment roadshow" on its upcoming IPO of tracking stock for its Optronics components division (see Alcatel to Issue Optical Tracking Stock). Analysts worldwide will be briefed about the IPO, which is scheduled for the week of October 20 on the Paris and Nasdaq stock exchanges.

Alcatel's proposal highlights a trend among leading makers of networking gear to use the public markets to leverage their components divisions. Lucent Technologies Inc. (NYSE: LU) announced in July that it will create a separate publicly traded company from its Microelectronics business unit early in 2001. And a spokesperson for Nortel Networks Corp. (NYSE/Toronto: NT) says an IPO for Nortel's components business is "very high on the list of [the vendor's] strategic options."

On the face of it, component spinoffs look like a gold mine for investors. After all, the components segment is white hot, and RHK Inc. predicts it will grow in excess of $12 billion by 2003. But analysts warn investors to look carefully before leaping into an IPO or back-door play on the basis of glowing market forecasts.

For one thing, there's a big difference between issuing a tracking stock, as Alcatel plans to do, and launching a separate company IPO, as Lucent and Nortel seem to be planning.

Theoretically, tracking stocks, in which the parent company issues a new class of share specifically for a division or subsidiary, are supposed to let companies build value separately from their ordinary stock. The tracking stock usually is priced higher than the parent's shares, and it helps the parent raise and borrow money without diluting the value of its mainstream shares.

But many analysts question the value of tracking stocks, because they say they're expensive, complicate the shareholding structure, and don't reflect the proper value of the companies they're set up to leverage.

Take Alcatel's case: According to details given this week to European analysts, Alcatel plans to issue about 16.5 million shares of new Class O stock for Optronics, at a tentative price of 85 to 100 Euros per share (about $74 to $87 per share). The shares will carry the same voting rights as Alcatel's regular common stock Class A shares.

But here's a kicker: Dividends for the shares will be capped. They can never earn more than 1.5 times the ordinary Class A dividend. That's not good news, especially given that Alcatel's mainstream shares have dropped steadily through September and were trading yesterday at $66.38.

Alcatel says investors shouldn't be concerned about the cap, which it implemented chiefly to comply with French securities law. "The dividend doesn't bear on the value of the shares," says a spokesperson.

If Alcatel decides to spin off Optronics as a separate company with a separate IPO -- and that's still an "if" as far as Alcatel's concerned -- Class O shares will be traded for Class A shares. If the value of Class O stock is greater, Alcatel shareholders will receive the difference plus a 10 percent premium in cash. If Class O shares are worth less than Class A shares, however, Alcatel shareholders will forfeit the difference.

Bottom line? "The tracking stock isn't linked to the real value of the Optronics business," says an equities analyst in Paris, who requested anonymity. "Investors are tied to Alcatel's stock, not the performance of Optronics. Then, if Alcatel takes the company public in a separate IPO, nothing tells you as an investor that you'll get what Optronics sells for."

Some analysts think Alcatel would do better to follow the Lucent model and establish a separate company IPO for Optronics. "Companies need to ensure that component businesses are situated to best advantage. That doesn't happen if components are captive to your own systems business," says Max Schuetz, optical networking analyst at Thomas Weisel Partners. He says Alcatel's got a big strike against it, in that, like Nortel, it sells a large percentage of its components in house. (Lucent Microelectronics, in contrast, sells almost 2/3 to 3/4 of its gear to external customers, he notes.) Alcatel and Nortel's competitors, he says, already hesitate to buy parts from a company that's owned by a competitor. And that's going to hold back the growth of Optronics, with or without a tracking stock.

Does this mean Lucent's taking the best tack by spinning off Microelectronics in a separate IPO this spring? Perhaps, say analysts. But using the right strategy is no guarantee of riches for investors. Again, the devil is in the details. "They say Microelectronics is a $4 billion business. But $2 billion of that is modem ICs. That leaves a $1.6 billion to $2 billion optical business," says Schuetz. Possibly a decent investment, in Schuetz's book.

Other analysts are more bullish on Lucent's planned IPO, but discourage investors from a back-door play -- buying Lucent stock now in order to get a payout when it takes Microelectronics public this spring. "[Microelectronics] is the fastest-growing segment in Lucent. Its last quarterly revenue figures indicated 30 percent growth year over year," says David Toung, analyst at Argus Research, an equity research firm. But, he says, the prospect of a good investment in the new IPO "isn't a good enough reason to buy Lucent stock."

Others agree. "A back door play wouldn't be a good move right now," Schuetz says. Lucent's overall valuation is presently at low ebb (its market cap at press time was $103 billion). If investors buy Lucent stock now, they could lose out when they go to exchange those shares for Microelectronics shares at IPO time, he says.

The ultimate value of the new component spinoffs remains to be seen, but the message from experts: Don't rush in until the value of a particular stock is clear. "It all depends on the individual company," says Schuetz.

-- Mary Jander, senior editor, Light Reading http://www.lightreading.com

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