Bear Stearns recommends ONI Systems convertible on Ciena merger

By Ronda Fears

Nashville, Tenn., June 18 - Bear Stearns' new head of convertible research, Rao Aisola, on Tuesday recommended the ONI Systems convertible as the merger with Ciena Corp. was formally approved, which he said could provide an 8 to 9 point price gain in the bond.

The merger between the two telecom optical networking equipment firms becomes effective Friday.

"We are recommending the ONIS 5% convertibles for multiple reasons - a strong market presence, cash rich balance sheet and good convertible positioning versus the [Ciena] senior notes," Aisola said in a report.

He recommends outright convertible investors buy the ONI Systems converts.

For arbitrage investors, he suggests a 40% to 60% stock hedge.

Combined, the company has a fully integrated suite of products that spans both the long haul and the metro networking market, he said, which should drive cost synergies and make the collective range of products more attractive to the carriers.

"While most optical networking companies are not seeing strength in customer orders, carrier capex as a percentage of sales seems to be bottoming or at the very least decelerating," Aisola said.

A strong balance sheet gives cash rich companies like Ciena the means to invest in the next generation of products that carriers are looking for, he added.

Access build-out in broadband is a key area of spending for carriers presently, he said, and as that phase slows down and service development becomes a priority, metro and core vendors should benefit.

The ONI Systems convertible note due 2005 is trading at an implied credit spread of 1,200 basis points or a yield to maturity of 15.27%.

While the credit is currently not rated by any of the agencies, the analyst said it should soon become a Ciena credit, with senior debt currently rated B+/Ba3.

"We anticipate that the notes will trade up an implied credit spread of 800 bps over treasuries," Aisola said, noting the Bear Stearns B high yield index is at 700 bps, "implying a price upside of 8-9 points."

Aisola added that, "given the current economic environment, the company has incentive to buy back the higher coupon ONIS convertible notes to reduce interest expense."

Proforma cash will stand at $1.8 billion with $990 million in total debt for net cash of $810 million.

"In a worst case scenario, assuming CIEN/ONIS pays down its debt, it can survive for 4 to 5 quarters assuming a $125 million cash burn per quarter, a highly improbable $200 million all cash restructuring charge and modest synergies from the acquisition," Aisola said.

"This provides a comfortable cushion for the company to wait out the current carrier capex crunch."

In a conference call after the merger vote, Gary Smith, chief executive officer of Ciena, acknowledged the impact of the downturn in the telecom market, but said the ONI Systems addition better prepares the company for a rebound.

"We believe the combination of Ciena and ONI creates a new Ciena capable of offering one of the broadest next-generation solution sets available and extends our technological and market lead," Smith said.

"We continue to expect that once our carrier customers resume more normal spending patterns, a larger percentage of their expenditures will be directed toward cost-saving next-generation solutions like Ciena's."

Smith said Ciena and ONI would immediately eliminate functional redundancies, projecting to reduce their combined workforce by about 225 employees on Wednesday and another 110 employees in the next three months.

But, Smith said Ciena has maintained a commitment to research and development throughout the slump.

"We've got leadership in a number of areas," Smith said.

"It would be short-sighted to let that go. We're maintaining all our key R&D platforms."

Smith said that while the telecom industry appears to be at a trough, there could still be pressure on third quarter results. The company's fiscal third quarter ends July 31 and results are expected to be reported Aug. 22.

"We continue to navigate an uncertain telecom environment, one in which service provider spending appears to have reached unsustainably low levels. In this environment our business remains volatile and unpredictable, and our fiscal third quarter revenues will depend heavily on the timing of customer orders and acceptance of products for which we already have orders," Smith said.

"It is possible, however, that depending on the timing of acceptance and customer orders, Ciena's third quarter revenues, including revenues derived from ONI, could be down meaningfully from Ciena's stand-alone second quarter revenues."

Ciena 3.75% due 2008

Rating: B+/Ba3

Convertible Price: 61.5

Stock Price: $4.80

Yield to Maturity: 13.84%

ONI Systems 5% due 2005

Rating: Not Rated

Convertible Price: 74

Stock Price: $3.43

Yield-to-Maturity: 15.27%

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