I was invited by Rafik to do a guest post on Lightspeed. I considered various topics including the adrenaline rush we all get working on the “ragged edge” of accounting, but then it occurred to me that you can’t truly know Finisar without understanding our views on M&A. Finisar has used M&A extensively in developing its vertically integrated business model. In doing so, it has targeted a variety of companies, both private and public, big and small, foreign and domestic. To date, 12 transactions have been consummated in building our optics business although we looked at many more along the way and even backed out of a couple. And we have done so almost irrespective of the macroeconomic environment or stock price at the time of the transaction. As long as we felt the deal could be accretive within a relatively short period of time (generally one year to allow for restructuring although manufacturing synergies can take longer), then the transaction qualifies for consideration. Of course, pure technology deals can take longer to pay off and generally require that we take a healthy dose of skepticism before evaluating the opportunity.

How successful have we been with our M&A strategy? We ask ourselves that question all the time. We had a couple of false starts with respect to establishing an internal capability for building lasers (this is hard). And we had the chutzpah to announce a hat trick (3 deals at one time for those who don’t follow hockey) back in the internet bubble when we probably didn’t fully appreciate some of the integration issues you can run into. While some transactions have definitely worked better than others, we have never been shy about using M&A to sharpen our competitive edge. As noted in a recent Harvard Business Review article, “while M&A activity has been severely depressed since 2008 and fell dramatically in early 2009, acquiring companies during that period tended to outperform their industry peers in market valuation, according to a global study by Towers Perrin and Cass Business School examining 204 deals, each worth more than $100 million.”

In Finisar’s case, we have greatly expanded our product lines, patent portfolio and R&D capabilities through M&A. Our optics revenues have grown from just $47 million in fiscal 2000 when we became a public company to an annual run rate of over $580 million as of the most recent quarter reported and was headed higher based on our guidance at the last earnings call. In the process, we have become the world’s largest supplier of optics for communications applications. But “being big” is not what drove our M&A strategy. To understand what did, we need to take a walk down Finisar M&A Lane.

In the heady days of the internet bubble, we should remember that did not make any of the key components that were used to build our transceivers such as lasers or ICs. Furthermore we built all of our products using outside subcontract manufacturers instead of doing it ourselves. During that time, we were at the mercy of some of our competitors in terms of obtaining key components. Without an adequate source of supply, market share can suffer as key customers direct more of their orders to those who are most likely to supply enough product in the timeframe needed. In addition, attempts to introduce new products earlier than our competitors were compromised as a result of not having early access to new versions of those key components. Our experience from the bubble underscored the importance of vertical integration for certainty of supply and for accelerating product development while having our own off-shore assembly and test operation was going to be important in order to control access to our technology and exercise greater control over product quality while keeping costs low. It wasn’t until later that we realized that having an internal manufacturing assembly and test capability also gave us the ability to respond more quickly to upside surprises which happens almost irrespective of the economic environment at the time.

If we just look back at the goodwill we wrote off in fiscal 2009, you could reach the conclusion that we sometimes venture off the reservation. But goodwill impairments are almost inevitable given the macroeconomic cycles we must work through periodically. In the case of Optium, we entered into a merger agreement where we agreed to issue shares for a certain percentage of the combined company in May 2008 which determined the amount of goodwill that would be booked. The transaction was finally approved by shareholders in the fiscal quarter ended October 2008. During that same quarter, Wall Street went into a meltdown and the economic consideration of what we had issued was no longer supporting the amount of goodwill that was generated according to the rules of GAAP accounting. As a result, we were forced to write off all of the goodwill in the same quarter that it was generated. Would we have done the same deal had we fixed the exchange ratio much later when our stock price was lower? Of course we would, because Optium’s stock price would have been lower as well. A falling stock price does not mean the relative contribution of each party to the value of the total has changed. If we had done the same transaction later in the year when stock prices were lower, the amount of goodwill written off would have been considerably less or perhaps none at all. The fact that companies record a goodwill impairment is sometimes more a statement about the economy at the time the transaction was undertaken rather than a problem with the transaction itself.

So how successful have we been with our M&A strategy? I’d say good enough so we aren’t shy about considering new opportunities, but have earned just enough credits from Hard Knock U. to be very careful as we evaluate them.

You may have heard that last week Finisar announced the sale of our Network Tools (NT) business to JDSU. For those of you how know us primarily for our optics products, I’d like to give a brief history of our Network Tools business.

It was started in the early 90’s as an internal development effort to avoid buying expensive test equipment for building 1 Gbps optic modules for Fibre Channel. Later, it went on to become a leader in products like the Xgig, the storage industry’s number one protocol analyzer and data generator platform. During our last fiscal year, Network Tools achieved $44.2M in revenue, but while profitable, contributed less than 10% of our total revenues. This division had a different business model than our optics business with higher gross margins and higher operating expenses but slower growth. As every industry sector generally trends toward consolidation, it was logical for this division to be part of a larger operation.

While this business contributed less than 10% of our total revenues, we are very proud of the accomplishments of the NT team. We wish them much success in their new home.

The ultimate benefit to Finisar is that we remain focused on our core business of delivering the best optical communications products in the industry where our transceiver/transponder business is number one in market share.

Please feel free to share your thoughts on this topic in the comments below.