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MRV, Luminent, and Fiberxon

image MRV (MRVC)  completed a merger with component maker Fiberxon without having audited financials and released an 8-K outlining events that do not point towards rapid resolution. In my personal opinion, the company has willingly placed itself in a situation where they face imminent delisting, violation of Bond covenants, and virtually certain attack from shareholder lawsuits and activists. It defies explanation.

MRV is a technology conglomerate with multiple telecom equipment and component product lines. Luminent is the operating unit for optical components and has healthy market share in the FTTH space. MRV announced that they would be merging Luminent with Chinese component manufacturer Fiberxon, which also had been doing well in the FTTH component area. On paper, a very smart move, one I agree with. Unfortunately, while it was a fantastic idea I couldn’t concoct a more difficult one to execute (see “Cornering the Commodity Market“).

I am a vigorous supporter of consolidation in the Telecom components area but was concerned about the sheer force of will required to weld these two disparate companies together. The source of my concern was the financial, cultural, and logistical difficulty in integrating a Chinese company into a public US Company.

Barron’s has an excellent summary of the 8-K that should be read. The sequence of events reads like this.

  1. MRV discovered accounting irregularities at Fiberxon during the due diligence period that called into question the reliability of historical financial statements.
  2. The discovery of these issues led to the termination of both the Fiberxon CEO and VP of Finance.
  3. Auditors hired by Fiberxon to sign off on three years of audited financials question commitment of Fiberxon?s management to maintain reliable financial reporting systems under both US and PRC accounting standards.
  4. Auditors walk away from the auditing engagement in June when they determine insufficient progress was made by Fiberxon to correct identified issues.
  5. MRV decides to proceed with merger regardless.

What truly defies explanation is step 5. MRV has willingly placed themselves in a situation where audited financials must be completed within 75 days or they face Nasdaq delisting and subsequent violation of loan covenants. MRV itself indicates that meeting this guideline “Does not seem likely”. In addition, this decision radically curtails access to additional capital and suspends their ability to spin off the new Luminent business unit in an IPO until audited financials are completed.

Auditors will happily pound away at a companies books, regardless of the complexity of the problem. More complexity is great for them as it generates more billable hours. Investors in Vitesse Semiconductor (VTSS.pk) experienced this largess firsthand. Auditors only walk away when they feel their efforts are truly hopeless or when their integrity is at stake. It appears the amount of effort required to complete the audit is large. From the 8-K:

to do so will require a forensic examination of Fiberxon?s business, operations and financial condition and records <…> potential reconstruction and reconciliation of erroneous or falsified business and financial records, preparation of the necessary financial statements and their audit by independent public accountants

One bright spot – the Equity holders of Fiberxon don’t get paid until this is resolved and audit costs will come from their pocket. No mention of liability to MRV itself for making this decision though.

In the absence of additional commentary from the company, the only rational explanation for MRV’s decision to go forward with the merger is that they intend to become a private company. If a bid already does exist and an agreement is in place, this should have been disclosed. Perhaps the company feels confident one can be solicited ex-post-facto.

Fiberxon is a good company and I believe MRV when they said:

Despite Fiberxon’s difficulties in providing us with audited financial statements prior to closing, we believe that its fundamental business is sound, its employees are committed and enthusiastic, and that its presence in the People’s Republic of China provides MRV and Luminent a key strategic advantage.

It makes no sense to me why the merger would be consummated prior to having audited financials. Why not delay the merger until accounting issues could be resolved? In my opinion the company has unnecessarily put themselves and their investors in a terrible and costly position.

This is worth watching as more details emerge.

Author owns no position in MRVC and holds an immaterial VTSS short position

Discussion

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  1. I am sure there is a good reason for this, one would think if they structured it as an asset sale and not a merger all this could be avoided.

    Posted by Herb | July 4, 2007, 10:12 AM
  2. A rigorous accounting standard has yet to be adapted in most of Chinese companies. It is common for public traded companies to move around assets to dress up earning. Though it is a practice common in all companies ( US or China), those from china did not have the law to force them disclose the situation publicly, the potential deficiencies are impossible to spot from the book. On the plus side of the lack of regulation, I doubt lawsuits by shareholder in China are as rampant as those in US.

    Posted by yf | July 5, 2007, 3:04 AM
  3. Main land china is one of the few places on earth where US dollar still hold its 1999 value due to the currency peg.

    Posted by yf | July 5, 2007, 3:12 AM
  4. There are alot concerns regarding why not delay the deal until the numbers are cleaned up? To get historical mess audited is not going to happen fast, while to move forward with acquisition certainly risk drawing the stock into Nasdaq non-compliance, delisting could easily get the pricing below 2 bucks etc, and lot of others…….

    I have the feeling they know what they are doing by measuring the cost versus forseeable gains. I believe enough risk analysis was done by the board as to determine under what condition the acquisition should be delayed or moved forward. We are now counting on MRVC’s mgmt ability to sort this out. There obviously exist the confidence on doing this, but historically MRVC has been very conservative in doing acquisistions associated with this kind of issues if comparing with their competitors like JDSU, FNSR. This is the more scary part, I guess.

    If you recall right the MRV’s aborted deal with HG Genuine, sound to me MRVC cannot affort to fail another one, the Fiberxon deal has to go through at whatever the cost. IMHO, the strategic reasons for this deal remain unchanged: catch up the increasing demand, remove major competitor, dominance PON optics space, access china mkt and manufacturing, etc etc.

    Beyond this, I am aware of a competitive bid, which was much higher than its offer. MRV may feel they are paying much cheaper than they had originally thought possible.

    What a shareholder has to bet is everything MRV could gain by doing this could be subsumed in the accounting issues. To MRV, stock is probably considered sencond to business sales in short term. Particularly ture for doing PON business, price pressure make the access to china mfg critically important.

    Their intent is clearly to continue its path to IPO Lumi with Fiberxon. If there is anything likely to be taken private, this could be MRVC, hopefully after IPO.
    Anyway seems the original MRV business become less and less critical nowadays.

    On the other hand for the worst senarios, there are lots of smart people who do very stupid stuff in this industry. Given the uncertainty we are facing, the question should be is the risk worth it?

    Posted by FC | July 15, 2007, 2:01 PM
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