NeoPhotonics: Merger Arbitrage

NeoPhotonics (NYSE:NPTN), an optoelectronics manufacturer, is being acquired by one of its larger peers Lumentum (LITE). The offer is an all-cash transaction equal to $16 per share, around a 3% spread currently. The downside to pre-announcement levels is around 40%. The merger has been approved by the majority of the NTPN shareholders. The transaction is expected to close in the back half of 2022. The only hurdle hanging is the regulatory review by SAMR (Chinese antitrust authority).

If the transaction closes sometime in the next 2-3 months (Phase two regulatory process lasts up to 90 days after which the company can get approved right away or go into the phase 3 which would take another 60 days) quick 3-4% spread seems to be a decent play given the current market volatility. Moreover, it is not unlikely that in the midst of the current market turbulence spread might still increase for reasons not related to the merger which makes the setup at least worth tracking. The major risk is if the transaction timeline gets extended beyond the expected close in the back half of the year.

Since the announcement in November 2021, the spread hovered at around 7%, largely reflecting the regulatory concerns. Recently, the spread narrowed to 3% on the reported news from several sources that the review process entered Phase 2 with few objections raised by industry players. Moreover, a week after the update on NPTN/LITE merger, news came out that a merger between two of the largest players in the optoelectronics industry, II-VI, and Coherent, is progressing through SAMR review. This does not seem to be too much of a surprise given how the previous mergers in the industry have closed including acquisitions by some of the same players. As it pertains to the NPTN merger, it is likely a done deal given the NPTN's relatively small size in China and the industry at large. Plus China has several domestic players in the same industry with a large market share. For example, Innolight (about $4b Mcap) is a Chinese manufacturer of high-speed optical transceivers, one of the three largest suppliers in the world, the addition of the NPTN would not transform the dynamics of the market.

Previous Industry Acquisitions’ regulatory hurdles

Over the last couple of years, the Photonics industry has been going through a consolidation. Here are some of the M&A activities during this time.

• Lumentum’s acquisition of OCLARO was announced in March of 2018 and closed in 7 months. The acquisition was made to deepen the expertise in increasing space of the high-speed transceiver segment (e.i 100G+ speed and long-distance services) before the transaction transceiver legacy products were subscale 10G, 40G and just starting off with 100G speeds. As a result of the sale, Oclaro added $163m to LITE’s China sales of $183m in FY18. Current China sales for LITE stand at $500m for the full mix of optoelectronics products (breakdown on transceivers not available) vs 40b for the whole optoelectronics market with a large share of the market being in Asia.

• II-VI’s acquisition of Finisar (the largest transceiver manufacturer at the time) created a giant company in the space. The acquisition was announced in November 2018 and closed 10 months. The merger did not go through smoothly, the II-VI had to re-file an application to SAMR back in August 2019 when Phase 3 of the SAMR review was about to end. Instead, the transaction was pushed out by another 3 months. Though the company only received clearance in case they would agree to operate separately Finisar’s (Telecom end market products like WSS and not transceivers aspect of the business) wavelength selective switch business of Finisar for three years. The merger added more expertise in the high-speed, high distance segment to II-VI adding about $231m in total China sales to the then already large revenues of $300m in China. Moreover, both of the above-mentioned mergers closed in the midst of the US/China tensions.

• II-VI and Coherent merger saga have been going on for almost 2 years now. The main problem with this merger is the vertical integration between the players basically one of the largest laser manufacturers would be merging with the largest transceiver manufacturer (certain types of lasers are an essential component of transceiver infrastructure) two players already had a customer/supplier relationship before that is possibly why the transaction is taking so much time. Though, the recent news of the progress in such a case does seem to be reassuring. The combined sales of these two companies in China would be about $1b with about $300m coming in from Coherent. We can contrast this with the NPTN/LITE merger whose joint revenue in China would equal ~$600m, $90m of which would be coming from NPTN.

NPTN Business and acquisition rationale

NPTN is a manufacturer and seller of optoelectronic products that transmit and receive high-speed digital optical signals for Cloud and hyper-scale data center internet content providers and telecom networks. The company also supplies tunable lasers emitting ultra-pure light that is required for the highest speed over distance fiber-optic communications links. The company usually sells its products to contract manufacturers or network equipment suppliers such as Arista Networks, Ciena Corporation, Cisco Systems, Huawei Technologies, Infinera, Nokia, and ZTE. The company specializes in high speed, high distance products that operate at the highest speed over distance, at speeds of 400 Gigabits per Second ("G")+ and beyond data rates in a single wavelength.

The company has been growing quite well on the back of the increased demand for more data around the world. The company has especially benefited from the increasing demand for cloud storage solutions and the implementation of the 5G technologies over the last decade. NPTN has some exposure to the Chinese market both through manufacturing as well as the direct sales of its products. For a long time, Huawei was the company’s largest client at one point representing over 50% of total revenues. Increasing tension between US and China has significantly affected the company’s top line as well as its ability to generate cash flows. Despite the industry-wide headwinds due to US-China tension with the later semiconductor shortages and general supply issues, the company has shown impressive top-line growth (if the Huawei effect is excluded).

Some of the problems still remain to date. Specifically, problems of client concentration have not disappeared for the company despite diversifying away from Huawei in recent years. The company’s top four clients represent about 75% of revenues. Though, one distinct characteristic of the company is its focus on products that operate at the highest speed and distance with speeds of over 400G and distances of up 2000km. The rapid growth of 5G technologies and cloud & hyper-scale data centers would largely benefit players manufacturing high-speed optical solutions.

Currently, the broad optical communication and networking equipment market is valued at $24b poised to grow at 8.6% through 2030.

Lumentum (LITE) is one of the peers of the NPTN in the optical communication and network equipment market. In the past, LITE was mainly a provider of telecom transport equipment as well as industrial and consumer lasers (notably a provider of the 3D sensing lasers for the FaceID feature in iPhones). In 2018, they have acquired OCLARO adding transmission product capabilities of OCLARO such as coherent components and coherent modules. OCLARO mainly provided transceivers of lower speeds up to 100G speed with only later gradually introducing higher speeds solution as a joint company. The acquisition of NeoPhotonics' products adds exposure to 400G+ optical network solutions in the fastest-growing part of the industry, greatly enhancing LITE’s ability to grow in these markets. In addition, the two companies expect ~$50 million in run-rate synergies within 24-months of closing. This should be enough to put the NPTN over the hump on the road to profitability plus the joint company will have a significantly diversified product mix eliminating the problem of revenue concentration NPTN has today.

LITE CEO from Q2 2022 earnings call:

“We think it's a huge opportunity. And one of the -- parts of the calculus in the NeoPhotonics acquisition is that -- data center interconnects and connecting cloud data centers is a huge opportunity. And the transition to 400 gig, and frankly, a [transition] to kind of a more universal solution that all the major cloud operators are using creates a very large opportunity, both at the transceiver level as well as selling components into folks building transceivers. So we think between the combination, we will have all bases covered to do very well in that opportunity.”

Conclusion

This is a highly strategic transaction that is likely to pass its main hurdle, Chinese antitrust review. The high likelihood of the acquisition closing is reflected in the spread standing at 3-4%. Given that this transaction should close in a couple of months, a 3-4% quick merger arbitrage return might be a decent buy. Plus, I think, there is a good chance of a widening spread given the current market turbulence and the ongoing US/China tensions. It might be a good idea to track the spread and go in, once the spread is more attractive.