Bookham (BKHM) announced its fiscal Q4 results recently. Although there was nothing encouraging in the release per se, the bigger news was the prospective combination of it and Avanex (AVNX).

Note that Avanex attempted a merger with Oplink (OPLK, Hold) back in 2002, which didn't go through because the Boards of the companies couldn't come to terms. This time around, the Boards of Directors of both BKHM and AVNX have agreed to a merger.

Question is: Is it going to be synergistically incremental to the merged entity in terms of potential shareholder benefits, or is it a result of dire times?

The answer probably is: Both. Undoubtedly, the combination will create a larger optical component company with higher revenues and better margins and a line of product that will have significant breadth to make it more competitive. Given that both companies have already undergone significant restructuring in the past few years and have achieved relatively leaner cost structures, the emphasis for further restructuring should be minimal.

The merger should give the new entity critical mass in terms of R&D investment and meaningful operating expense reductions. The companies are targeting an annualized cost savings of roughly $28 million after completion of integration and expects to be EBITDA positive (on an adjusted basis) in its first full quarter of operations. Longer term, the companies also expect the combined entity to have a greater cash flow than the sum of the two companies separately.

On the product side, although there will be some overlap in optical amplifiers, the companies should complement each others' product lines, particularly in components, amplifications, dispersion compensation and subsystems. Avanex's amplifiers could potentially be complemented by Bookham's pump lasers, and Bookham's transponders can use Avanex's modulators for better performance.

Given that industry sources are projecting around 40% CAGR between 2008 and 2012 in global internet bandwidth demand, the combined companies may benefit from size and cost advantages in areas of integrated tunable lasers & modulators, lasers & detectors and intelligent sub-systems to capture a larger share of the growing broadband traffic.

Although the fundamentals continue to be challenging for the companies and sector as a whole, the proposed merger appears to be a sensible alternative to continue isolated in an already overcrowded component space. The proposed merged entity is expected to be an all-stock merger with Bookham shareholders owning 53% of the new entity. The current CEO of Bookham is also expected to be at the helm of the new company.

We continue our coverage of BKHM and AVNX with Hold ratings.