Is the Tellabs-AFC Deal in Danger?

Investors scared that Advanced Fibre Communications Inc. (AFC)'s (Nasdaq: AFCI) proposed acquisition by Tellabs Inc. (Nasdaq: TLAB; Frankfurt: BTLA) might collapse may be missing the elephant -- or, actually, the RBOC -- in the corner.

AFC has endured some tough times lately, and its shares shot way up before being pounded back to Earth. The fluctuation has caused investors to worry whether AFC’s relationship with Verizon Communications Inc. (NYSE: VZ), its most important customer, is in jeopardy, particularly since the RBOC is planning to bring on a second supplier of access equipment next year (see Investors Deprecate AFC-Tellabs Deal and Tellabs Calm Over AFC Hiccup).

Indeed, Verizon has fined AFC heavily for missing preset product milestones. And those fines are part of the reason AFC’s share price has tumbled. But Verizon is also the catalyst driving AFC into Tellabs' arms.

“Verizon is watching,” says Timm Bechter, vice president of broadband and wireless equipment for investment bank Legg Mason Inc. Verizon is an important customer for Tellabs, too, he notes. “They sell a lot of crossconnects to Verizon. It’s more than a possibility that Verizon wants this deal to happen.” For Verizon, the more mature Tellabs could help AFC fulfill the carrier's fiber-to-the-premises rollout (see Verizon's FTTP Demo Helps AFC).

This morning, Bechter slapped a Buy rating on shares of AFC, reaffirming his belief that the acquisition of AFC by Tellabs will happen "at the originally negotiated price."

Analyst Nikos Theodosopoulos of UBS Investment Research has a different theory. He believes that Tellabs will first succeed in getting AFC to lower its price to one share of Tellabs plus $7 per share in cash (from 1.55 shares of Tellabs plus the cash). He says this is based on AFC's disappointing second-quarter results, its lowered guidance for the rest of the year, and the Verizon penalties it must pay. “Tellabs views it as a strategic acquisition,” Theodosopoulos says. “Our opinion is the deal will be renegotiated.”

That is easier said than done, however, as a repricing may create ill will. One thing a buyer does not want is to anger future employees, who are key to developing new technology. And according to an S-4 registration statement Tellabs filed with the Securities and Exchange Commission (SEC) on June 23, executives of the two companies spent 14 months negotiating the deal and took into account fluctuating stock prices in determining the deal price. They did not include a so-called "collar," which would have set basement and ceiling prices on the deal. The S-4 also warns investors that the deal is fixed and would not be changed because of stock price fluctuations.

Under the current terms of the transaction, AFC shareholders get 1.55 shares of Tellabs and $7.00 for each AFC share. Based on Tellabs' closing price ($9.19 a share) on May 19, Tellabs would pay AFC $21.24 a share, or $1.9 billion overall. Although the spread between the price Tellabs has agreed to pay and AFC’s share price has widened since the deal was made public, the spread is less now than it was when the two companies signed the agreement May 19 (see Tellabs Buys AFC for $1.9 Billion). While repricing would give Tellabs investors some short-term gains, Bechter says it could be disastrous in the long run. He says it would make Tellabs look foolish, since the problems with Verizon should have come up in the due diligence process, particularly since the two have been both close partners for years. It might also hurt Tellabs' reputation, considering it walked away from its $7.1 billion merger with Ciena Corp. (Nasdaq: CIEN) in 1998.

In addition, killing the merger would cost Tellabs dearly -- the company would have to pay AFC as much as $38.8 million as a penalty.

Both companies need this deal, says Albert Lin, director of research for American Technology Research Inc., which analyzes tech stocks. “I think it is a merger for two companies facing a troubled market,” he says. “It is better for them to get together than go it alone.”

Tellabs is facing challenges of its own in keeping customers: Cingular Wireless and AT&T Corp. (NYSE: T) have been revising their spending plans and are no longer fully committed to Tellabs, according to Lin.

Lin says the deal may not be popular with investors now or a year from now. “But it needs to be done, because the alternative is worse."

As far as Tellabs is concerned, the deal is on. Says Tellabs spokeswoman, Ariana Nikitas: “We are analyzing any new developments. But our board has not changed its recommendation.”

A spokesman for AFC could not be reached.

Sources say AFC spoke to three other unnamed companies before accepting Tellabs’ offer, but most analysts and other industry watchers say Tellabs is the most suitable partner.

Ultimately, the deal will depend on how desperately AFC wants to be bought, says M&A attorney John Graham of King & Spalding. Graham points out that personal relationships drive the M&A business, and often deals collapse because one side ticks off the other. “People do crazy things sometimes,” he says.

— Marcy Burstiner, special to Light Reading