Adva Optical Networking (ADV.F) – Merger Arbitrage – 22% Upside

Current Price: €13.00

Offer Price: €15.87

Upside: 22%

Expected Closing: Q2-Q3 2022

Scheme document

Initial presentation

Updated presentation (2nd Nov)

 

This is a cross-border merger in the optical networking industry. The spread is very attractive, however, due to my limited knowledge of the industry and limited insights into the appropriateness of target's and the buyer's valuations, this is in the too-difficult bucket for me. Below I am posting some info on the transaction to help anyone interested to start their own due diligence.

German-listed optical networking services provider Adva Optical is getting acquired by its US peer Adtran. Consideration stands at 0.8244 ADTN per Adva share. 3.5m shortable shares are available on IB at 0.25% rate. The transaction is subject to approval by 70% of ADV shareholders and the majority of ADTN shareholders. The largest ADV shareholder with 13.7% ownership is already in favor. Consents from the German, US, and Australian foreign investment regulators are also outstanding. The biggest risk seems to be ADTN shareholder approval, given the shares slumped after merger news and have somewhat recovered since potentially due to management's efforts to explain the strategic rationale of the transaction as well as Q3'21 results. Downside to pre-announcement levels stands around 12%. The merger is expected to close by Q2-Q3 2022.

 

Regulatory approvals

The merger requires a bunch of regulatory consents, some of which have already been received. As both companies are relatively small and their market shares in Germany/US/Australia are minor, antitrust approvals were straightforward. However, foreign investment regulators might take longer to approve as as both firms provide services to government agencies.

Antitrust approvals:

Foreign investment approvals (national security):

  • Germany - opened a formal review, which is expected to last for four months (is expected to wrap-up by the end of February). ADTN generates 10% of revenues in Germany and ADVA - 20%.
  • US - 'voluntary notice' submitted to CFIUS on the 2nd of November. However, as the buyer is a US company and the CFIUS approval is needly only because the target company will add 3 board members to the board of the combined company. If that's the case, the approval should be a formality. The review is expected conclude in Q1'22. ADTN generates 67% of revenues in the US and Adva - 36% (in the Americas, so including LATAM).

A voluntary notice of the Business Combination will be filed with the Committee on Foreign Investment in the United States ("CFIUS"), because the Target, a foreign entity under U.S. law, will appoint three members of the board of the Bidder post-closing.

  • UK - received.
  • Australia - the response is expected between the 19th of January and the 19th of February.
  • Spain - received.

 

Adva Optical shareholder approval

Approval from 70% of Adva Optica shareholders is required. Several factors suggest the offer values the company appropriately:

  • The consideration comes as all-stock, so Adva's shareholders will be exposed to the further upside opportunity of the combined company (and scale is important given the macro tailwinds).
  • The largest shareholder Egora Group supports the merger with its 13.7% stake.
  • Before Egora, the largest shareholder used to be Teleios Capital (PE firm based in Zurich) - owned 19.4% in Dec'20. However, Teleios has reduced its stake to below 3%. By the end of Jan'21 it still owned 12.5% and its not exactly clear when did it dispose of the remaining shares, however, for sure it was below the current prices or the offer consideration.
  • Although not a reliable indicator, shortly before the merger announcement, most of the analyst' target prices were actually in line/slightly below the current offer price (from the scheme doc):

 

ADTN shareholder approval

Right after the announcement, ADTN's share price slumped by 17% and continued to decline in the coming days - a clear sign market believes this is a value destructive transaction. Shares have since somewhat recovered and now trade 12% below pre-announcement levels.

We're not exactly sure what is the concern here - it could be that shareholders preferred ADTN to pursue organic growth opportunities and are afraid that the merger of this size will become a huge overhang with which ADTN's management will not be able to cope. In other words, ADTN management track record is not exactly great and there might be some implementation/integration risk involved here. Analysts' questions on the conference call also reflect this concern (see below). Nonetheless, I think the management has explained the strategic rationale well and that shows in share price recovery. The largest shareholders are two index funds (will likely vote with proxy firm advice) - BlackRock with 16% and Vanguard with 11% - as well as Victory Capital Management with 8.5% ownership.

From the merger conf. call:

Analyst

I want to ask what could be a couple of areas of pushback and just to get your take on it, Tom. I’m going to ask them both at the same time. Number one, what would you say to people who say, “Well, we think that there’s a better story here for broadband access than for metro and enterprise and optical”, and why would you want to diversify away from broadband access, considering all the broadband stimulus and so forth? Then the second one would be, why double down on hardware when you have a competitor, specifically in Calix, that’s moving towards a subscriber, recurring revenue business that’s moving away from hardware?

ADTN CEO

Yes, let’s take them in that order. There’s not a material customer that we sell to today that, when they’re upgrading their access infrastructure, isn’t looking at also upgrading their middle-mile infrastructure. They’re very, very complementary and I see the uptick that we’ll see on the broadband side is very similar to the uptick that we’re going to see as people have to expand. You’ve got to understand that, when you’re talking about not just moving from DSL to PON, but we’re talking about people moving from one-gig PON to 10-gig PON, and that infrastructure upgrade is going to have multiple upgrade points through the network. We plan on being able to fill in that opportunity or see the upside of that opportunity as far back as we can into the network.
The other thing is I do think the initial decision points here are—although the market growth that we’re experiencing and going to experience is long-lasting, decision points on some of this infrastructure is relatively quick, as you’ve seen. I think the boost that it gives us in Europe and being able to have a much broader footprint of established relationships and being able to make sure that the broadband piece goes our way and the middle-mile piece goes our way, is important, and similarly here in the U.S. I mean, we’ve had a huge run-up in new customers over the last year and a half, all of which have some type of backhaul requirements.
The second piece is—the software piece here is as compelling as the hardware piece. They have SDN components and NFV components that will materially help us on the enterprise part of the network. I think what you’re talking about in the competitive basis, somebody that’s focused very much on the Tier 3 residential space, and although that is something that we have a complete product portfolio to go and address, and as you probably are aware, we just recently announced our Mosaic One platform which squarely hits at that in a—it’s just, in many facets, a better product.

And another question regarding integration:

Analyst

Tom, before you guys go, one other quick question. Correct me if I’m wrong, but you haven’t done a deal this size, and frankly, it was a very different deal. You’d have to go back to when you acquired what was then Nokia’s broadband access business, and that obviously was within your core competency of broadband access. Every deal’s very different, and that certainly was very different than this one. I don’t think you’ve ever done a deal, anything close to this. The short question is—and I recognize you just announced this. But any thoughts on—integration is always a challenge…

ADTN CEO

Yes.

Analyst

…and can set companies back light years.

ADTN CEO

Right, right.

Analyst

Any thoughts on how you’re going to pull off this integration?

ADTN CEO

Yes. The majority of the time—we’ve been working this for some extended period of time, and the majority of that time has been making sure that we have an integration plan that’ll work. In many respects though, the good thing is I think culturally, we see a really good fit. That turned out was also the case with NSN.

We see, systems wise, where they are with their systems and where they are, ERP systems and things like that, very good fit. We looked explicitly into the product portfolios and understanding where things dovetail and where things don’t. There are some challenges, but I would say some challenges that we see in the integration as of right now, the challenges we see in relation to trying to pull a subunit out of a much larger company, as of right now, knock on wood, but I think it is very manageable. I’m going in with much better visibility to what we’re trying to get done and how we’re going to get it done than I did when we entered the NSN piece, which was very successful.

 

Synergies

The merger will combine ADTN's fiber access and aggregation, residential enterprise connectivity and cloud-based network optimization solutions with ADVA's fiber backhaul and data center interconnect, enterprise fiber access and connectivity, and network synchronization solutions. Due to low product/services overlap management presents merger as highly synergistic and expects to create vertically integrated fiber networking solutions provider. Both firms have complementary geographies and expect significant cross-selling opportunities - US$60-$120m revenue synergies (10% of combined revenues on a higher-end). Cost synergies are estimated at $52m from supply chain efficiencies and operating model optimization.

 

 

The buyer expects that with a higher scale it should gain a strategic vendor status with certain carriers. In addition, wider services and product portfolio will help to get more wins.

 

Industry tailwinds

The merger is happening at the time when the optical networking industry is seeing major infrastructure investments by US and EU governments and private companies to modernize communication networks (e.g. upgrading to 5G). Switch from Huawei to western suppliers also presents over $1.2bn revenue opportunity. Management expects the combined company with its higher scale and larger portfolio to capitalize on these trends much better.

A few quotes from the conf. call:

Let me summarize the secular developments that have created the Capex tailwinds underlying our combined company’s value creation. The pandemic has highlighted the need for service providers, governments and businesses to quickly build a robust digital infrastructure, the backbone of which will be fiber. Government subsidies in the U.S. for building out fiber infrastructure are expected to be more than double in the upcoming years, including funding as part of the Infrastructure Bill, Rural Digital Opportunity Fund and a growing base of state-level funding here in the U.S. In Europe, similar initiatives are underway with more than $45 billion of government funding programs proposed to provide universal high-speed broadband connectivity. Communication service providers are rapidly shifting their supplier preferences to those they believe favor their long-term interests. This is an opportunity given that our combined company will have a more comprehensive portfolio, broader global presence and an increased scale to capitalize on.

[...]

There’s kind of a land grab going on right now, and the person that gets there first wins. That land grab is not just because of the market opportunity created by all this stimulus, but it’s because of the displacement of Eastern vendors out of that market. For us to capitalize on longer term and maximizing—and I think the difference is huge thus far. Another 5% market share or 10% market share, as it plays itself out over the next five to 10 years, it’s monumental in size to be able to move the needle that far. I think it’s similar here in the U.S. Honestly, I think in some spaces, in the Tier 3 spaces, it’s probably not as large yet, but I think you’re going to see a similar thing happen in the U.S. where ADVA just didn’t have the same relationship profiles as we’ve been able to build over the years. I think they’re very complementary that way.

Also, both CEO's (Thomas - ADTN, Brian - Adva) basically confirmed that both firms' clients are looking favorably at this merger (cia not sure ar relevant, bet almost):

Analyst
Asked differently, what I was hoping to get from you was, I’m sure you’ve probably run this idea of the merger with customers. To what extent did your customers encourage you to talk to each other?
Thomas Stanton
I think on both sides, and I won’t speak for Brian, but I think on both sides, if you look at where our competitive—we effectively have one Western competitor that has, by far, the largest market share of non-Eastern market share. One of the things that would help us—I mean, basically, if I have a bigger bucket of products to sell, I really believe they want to buy that bigger bucket. I think, universally, it’ll be a positive thing.
Brian Protiva
I would just say a one-liner, and that is, I know that European customers both want a larger ADTRAN and a larger ADVA. This addresses that, especially some of the bigger opportunities that we’ll pursue together

Reportedly, several analysts have also commented positively on the merger.

 

Adtran

Adtran has two operating segments:

  • Network Solutions - software and hardware products that enable internet services for CSPs (communications service providers) and enterprise customers. ADTN's products and services enable companies' transformation to fiber/higher bandwidth residential services, cloud connectivity, ethernet, and optical networking for data center connectivity.
  • Services & support - includes a portfolio of services including network design and implementation/cloud management services.

These two segments span across three revenue categories - access & aggregation (solutions used by CSPs to connect their network infrastructure to their subscribers, these products are closer to the Central office of the CSP), subscriber solutions & experience (products/services that provide end-users access to CSP networks), and traditional & other products (legacy technologies such as DSL and HDSL).

In H2 2017 ADTN lost a large chunk of revenues from its major client due to the client's capital suspension program. Since then Adtran became unprofitable with gradually declining revenues. Currently, the whole sector is under pressure due to substantial supply chain constraints, which are expected to peak by the end of 2021 and normalize by mid-2022. However, due to global digitalization and various macro tailwinds (e.g. government's spending) the demand for Adtran services is rising and in Q3 ADTN recorded record bookings:

We are experiencing unprecedented demand, highlighted by our record-setting Q3 bookings – up 43% year-over-year. We continue to add new customers, including now three new Tier 1 operators since the beginning of the third quarter.

ADTN's CEO has been friends with Adva's CEO for 14 years now and the current merger was contemplated since mid-2019 (as per merger background disclosures).

 

Adva Optical Networking

Adva's products are based on three core areas - fiber-optic transmission technology, cloud access technology for rapid creation of innovative services and solutions for precise timing and synchronization of networks.

The segments are:

  • Optical networking - optical transmission solutions based on WDM (wavelength division multiplexing) technology. With WDM, multiple data streams are transmitted simultaneously over a single optical fiber by assigning each stream to a different wavelength of saler light. Every wavelength can carry a different application such as voice, video, etc. Combining (i.e., multiplexing) these wavelengths at one end of the fiber, transmitting them over distance, and then separating (i.e., de-multiplexing) them at the far end multiplies the fiber capacity and makes transmission more efficient. WDM is the foundation for all high-capacity networks.
  • Cloud access - ethernet-optimized transmission solutions for fiber-based networks. Network operators use the technology to backhaul traffic from mobile base stations and to connect their enterprise customers. Over the years, Ethernet has evolved to be the key protocol used to carry applications in high-speed optical networks for data backhaul and the interconnection of routers.
  • Network synchronization - complete end-to-end solution portfolio for synchronization technologies.

COVID impact was minimal and resulted mostly in slowed down growth - in 2020 revenues grew 1.4% vs 11% in 2019, however, due to cost control the company generated better margins and profitability. 9m 2021 revenues continued to grow 4% YoY, while margins and profitability continued to improve. as well. 2021 full-year revenue guidance stands at €580m-€610m, 5% growth vs 2020 from the midpoint. The company has also been impacted by supply chain problems.

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