Tellabs and Ciena
by Phil Weiss
TOWACO, NJ (Sept. 11, 1998) - Last night, Al Levit shared some thoughts on his dumbest investment. Tonight, we're going to take a tag team type approach as I finish off this discussion.
Unlike Al, I didn't sell a stock in order to buy stock in Tellabs (Nasdaq: TLAB). I just purchased it as part of my regular strategy of adding new money to the market throughout the year. The vast majority of my purchases this year have been of Cash-Kings. My purchase of Tellabs was one of my rare ventures this year into the land of Cash-Princes that I thought had the potential to become Cash-Kings. However, I could have just as easily purchased the same stock (Dell) that Al sold to raise money for his Tellabs purchase.
Like Al, I believe that it's important to have a good quality telecommunication stock or two in my portfolio. When I looked at the numbers, Tellabs looked like a real winner. The only one of the numerical Cash-King criteria in which it fell a little short of our target levels was its Flow Ratio. However, as of the end of the first quarter, this number, which had been trending down, was 1.55. Since the company also had no debt, I was comfortable with the Flow Ratio at that level, especially in light of its downward trend. However, I also knew that it was something that I would have to keep an eye on in the future.
I then read through the sections of Tellabs' 10K (available from http://quote.fool.com) that I find to be most relevant to make sure I had an understanding of its business and the related risks and opportunities. I decided to purchase an initial stake in the business that amounted to less than 5% of my stock portfolio. Not long after I purchased shares the stock started to increase in price rather rapidly. Second quarter earnings were released, and they easily surpassed expectations. Before I knew it I was up around 35% on this stock.
My first concerns came about when I went through what was viewed by the financial media as a great earnings report in a little more detail. The Flow Ratio had increased from 1.55 to 2.01. I looked at its components and, initially, I was confused by what I found. After I figured out what had happened, I started a thread on the topic on the Cash-King Strategies Board. The first message in this discussion can be found by clicking right here.
Here's a summary of what I concluded about the change in Tellabs' Flow Ratio: The component of the ratio that actually changed the most was the decrease in current liabilities. The current liability that decreased the most was accrued liabilities. Since that's the case, maybe the low Flow Ratio was a bit misleading in the first place. Accruals being what they are, I hate to think that the presence of accrued liabilities on the balance sheet supported the lower Flow Ratio.
All of this left me a bit uneasy about the rather dramatic change in Tellabs' Flow Ratio. So, I decided that I would continue to keep a close watch on this ratio, but I continued to hold the stock. What I may not have given full consideration to at that time was whether or not the change in Tellabs' Flow Ratio could in some ways have been a foreshadowing of what was to come. I say this even though the precipitous drop in Tellabs' share price coincides with problems that Tellabs' prospective merger partner Ciena (Nasdaq: CIEN) has had.
But, the Flow Ratio is also one of the tools that we use to evaluate management, so its increase could be viewed as a possible sign that other troubles were on the way. I say this because I do not think that Tellabs management has done a very good job in managing the combination with Ciena.
Initially, the merger with Ciena looked like a great business decision; however, it has gone VERY badly so far. The reasons for this merger were primarily related to the fact that Ciena has some very successful products that use optical fiber, but they have been unable to reach as much of the market as they would like with these products. One of Tellabs biggest strengths is its well-respected sales force. It was thought that it could significantly expand the market for Ciena's products.
After it was learned that Ciena would be losing a potential source of revenue in 1999 from AT&T (NYSE: T), the original deal was renegotiated from a 1:1 to a 5:4 stock swap. This resulted in a decrease in the value being paid for Ciena from nearly $7 billion to approximately $4 billion. (Note that as of Thursday, Ciena's market cap was down to under $2 billion).
When the parties agreed to reduce the exchange ratio in the merger, they held a conference call that I listened to with interest. I have to say that I was not left with a warm and fuzzy feeling after listening to the call. The thing that I was most uncomfortable with was that Tellabs' representative on the call (I believe it was its CFO) didn't seem to be able to quantify many of the analysts questions related to what types of savings and revenue benefits would result from the merger. He often answered with responses along the lines of "we haven't quantified that yet," or "I'm not sure."
Listening to the call left me with some doubts about the quality of the due diligence efforts of Tellabs in the transaction. The apparent surprise in reaction to each piece of bad news that Ciena has announced has forced me to start questioning the quality of Tellabs' management. After all, we've seen what's happened to the stock price of Cendant (NYSE: CD) as a result of its improper due diligence when it acquired CUC.
Wednesday we learned that Ciena had lost more business to a competitor. Once again Ciena claimed that this business loss was not significant. Yet, the value of the contract that Ciena lost was $100 million over the course of 3 years. Ciena's revenue over the last 12 months is $521 million. If the $100 million were to be paid equally over the next 3 years it would still amount to 6-7% of Ciena's current revenue base. This does not seem like a totally insignificant event to me, especially when there has been no information provided yet backing up Ciena's claim that the revenue it lost from AT&T would be replaced.
In light of the market's behavior on Wednesday and Thursday of this week and Tellabs relatively strong performance compared to that of Ciena, it seems to me that the market believes that this deal won't happen. Although I thought Ciena 's product line filled an important niche for Tellabs, I'm no longer certain that I want to get in bed with the "mess" that Ciena seems to be.
The closing of the merger has now been delayed until November to give the SEC and shareholders sufficient time to study the revised situation. There is speculation that this uncertainty is holding the price of Tellabs down in the interim. I know that at this point I will not be all that upset if the merger is put on hold, restructured into some type of joint venture or called off altogether until Tellabs has a full understanding of what they are buying -- at this point I just don't believe that they do.
Maybe the moral of this is that the significant downdraft in Tellabs' Flowie was more of a signal that the company's management was not doing as good a job at managing its business than I had thought originally. Now, I certainly don't like losing money, but the one good thing about all this is that sometimes we can learn even more from our mistakes than our successes. So, if this really does end up being a bad investment over the long term, then I'll do my best to take the knowledge I've gained from it and use it to my benefit in the future.
I'll be back next week with a full week of reports. I hope y'all have a Foolish weekend.
Day Month Year History C-K 4.01% 6.65% 5.10% 5.10% S&P 500 2.94% 5.38% 0.30% 0.30% Nasdaq 3.55% 9.50% (1.48%) (1.48%) Cash-King Stocks Rec'd # Security In At Now Change 2/3/98 24 Microsoft 78.27 104.25 33.19% 2/3/98 22 Pfizer 82.30 100.50 22.12% 5/1/98 37 Gap Inc. 51.09 59.75 16.95% 6/23/98 23 Cisco Syst 86.35 92.75 7.42% 2/13/98 22 Intel 84.67 84.94 0.31% 8/21/98 22 Schering P 95.99 94.63 -1.42% 2/27/98 27 Coca-Cola 69.11 62.44 -9.65% 2/6/98 56 T. Rowe Pr 33.67 27.75 -17.59% 5/26/98 18 AmExpress 104.07 79.25 -23.85% Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Eastman Ko 63.15 78.00 23.52% 3/12/98 20 Exxon 64.34 70.56 9.68% 3/12/98 15 Chevron 83.34 82.50 -1.01% 3/12/98 17 General Mo 72.41 56.44 -22.05% Cash-King Stocks Rec'd # Security In At Value Change 2/3/98 24 Microsoft 1878.45 2502.00 $623.55 2/3/98 22 Pfizer 1810.58 2211.00 $400.42 5/1/98 37 Gap Inc. 1890.33 2210.75 $320.42 6/23/98 23 Cisco Syst 1985.95 2133.25 $147.30 2/13/98 22 Intel 1862.83 1868.63 $5.80 8/21/98 22 Schering P 2111.7 2081.75 -$29.95 2/27/98 27 Coca-Cola 1865.89 1685.81 -$180.08 2/6/98 56 T. Rowe Pr 1885.70 1554.00 -$331.70 5/26/98 18 AmExpress 1873.20 1426.50 -$446.70 Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Eastman Ko 1262.95 1560.00 $297.05 3/12/98 20 Exxon 1286.70 1411.25 $124.55 3/12/98 15 Chevron 1250.14 1237.50 -$12.64 3/12/98 17 General Mo 1230.89 959.44 -$271.45 CASH $48.07 TOTAL $22889.95 *Please note: On 8/4/98 $2,000 cash was added to the