|Nortel's Bankruptcy Filing Enables Radical Change, Not Just at Nortel
Dana Cooperson & Matt Walker, Analysts, Ovum
On 14 January 2009, Nortel Networks moved beyond talk of divestiture and speculation of bankruptcy, and filed for creditor protection in Canada and the U.S., with Nortel UK entering administration separately under a filing managed by Ernst & Young. The company reached this point after multiple management regimes failed in their attempts to remake the company after the bursting of the telecom bubble. Nortel's move may result in a more balanced industry structure for communications equipment.
No immediate, significant industry impact from the filing...
There is no immediate industry impact from this filing, as Nortel's downwards spiral has been gradual and bankruptcy restructurings take time. For Nortel's three key constituencies - customers, investors and staff, the announcement reinforces but does not fundamentally change earlier concerns. The latest phase in the Nortel saga began four months ago, when it pre-announced Q3 2008 earnings (guiding down expectations), publicly put a 'for sale' sign on its Metro Ethernet Networks (MEN) division, and then mapped out yet another reorganization.
At the time we stated that a more radical approach than divestiture was needed to cure the company's woes. The bankruptcy filing is radical, but it will be exploited by competitors. They are now in a strong position to remind customers that Nortel can no longer give assurances of continued development of any specific products, which will surely impede Nortel's ability to bring in new business.
...but it highlights how the macroeconomic meltdown will punish companies with high debt exposure
This harsh market will expose companies with ailing balance sheets and put their survivability at risk. As during the 'dotbomb' period of 2002-03, issues of cash burn rates and leverage ratios now matter more than speeds and feeds and technology roadmaps. Debt restructuring can give struggling companies breathing room to radically change and return in a different form or make their businesses more attractive for acquisition.
'The new Nortel' may be unrecognizable as a result of business/product-line shutdowns and asset sales, leaving opportunities for other vendors
One of Nortel's perpetual struggles, going back to the 1998 acquisition of Bay Networks, has been in integrating acquired assets effectively, and more broadly fostering collaboration across divisions. Multiple attempts at top-down restructuring have failed to break down Nortel's silos and create a sustainable cost base; top-line change did not always filter down into product design or cost structure.
Prior to this week's filing, Nortel was in the midst of moving from four to three business units by folding bits and pieces of its Services division into the respective MEN, Enterprise Solutions and Carrier Networks business units. The aim was to create three standalone operations with a more focused set of offerings and resources. Some elements of this restructuring are undoubtedly positive; for instance, rationalization of the Enterprise product line and phasing out some legacy technologies. However, this change follows numerous incremental divestitures or shutdowns of specific businesses and product lines (for example, broadband access and the UMTS and WiMAX RAN segments) in an attempt to focus and differentiate while cutting costs.
By entering bankruptcy protection, Nortel's fate will now be largely determined by its creditors and the courts. Hence the restructuring ahead will be much more brutal and less under Nortel's control: product lines, technologies, partnerships, divisions, and even customers (i.e. installed base) will be candidates for shutdown or sale to the highest bidder.
We believe, though, that in Nortel's bankruptcy lies the opportunity for broader industry rebalancing. Specifically:
Taking on Cisco. In data networking, Cisco remains dominant in every region and in most product segments. In the first half of 2008 its $20.2 billion revenues were second worldwide in telecoms supply only to Nokia/Nokia Siemens Networks (NSN), and Cisco's financial results are far stronger: 1H08 net profit margin of just under 19%, and a level of cash and short-term investments 10.3x its monthly opex. For the same timeframe, Cisco with its peer group averaged a 6% profit margin and a 4x ratio of cash/investments to opex.
Cisco uses its market power and cash horde wisely to enter into new markets. For a company targeting Cisco, bits and pieces of Nortel's Enterprise and MEN units are clearly attractive. Juniper, Tellabs and Ciena would benefit from looking carefully at Nortel. All have some experience with growth through M&A, and have geographic and cultural similarities. They also have some product overlap, but buying a competitor just to get them out of the market is not an unheard of strategy. More important, Nortel has channel depth outside of North America, which is of high value to these companies.
40G/100G jumpstart. MEN's 40G/100G business, which Nortel now puts at 42 customer wins, defined as purchase orders or contracts that include 40G, not deployments, is an attractive focal point for a slimmed down Nortel or a competitor looking to limit its own R&D and jumpstart its customer list. Nortel has done a good job promoting its solution's viability over competitors' networks, so virtually all its competitors should be interested in this asset.
Diversification through acquisition. Ericsson's purchase of Marconi and Redback, after their respective bankruptcies, provides a blueprint for what is likely to be the ultimate outcome for Nortel: acquisition by a firm looking to fill out its equipment product line. For example, Ericsson and NSN both have gaps in their wireline portfolios and little position in enterprise. Acquiring significant chunks of Nortel may be attractive to both, and their relatively high cash reserves could make it possible: as of September 2008, both vendors had just under $10 billion in cash and short-term investments.
Evolution to 4G. Nortel's mobile infrastructure business is now focused on LTE/SAE (long term evolution/system architecture evolution). It is working hard to develop a strong LTE/SAE ecosystem including LG Electronics, LG Nortel and other partners. It is doing its best to demonstrate its capabilities through trials (e.g. Verizon and T-Mobile Germany) and announcements (e.g. a deal with KDDI) and expects some commercial launches in 2009. Its LTE assets (part of the Carrier division) may be attractive for another player, perhaps Alcatel-Lucent, NEC, or ZTE.
There may also be some 'rediscovered jewels' from the recent acquisitions that became lost in the Nortel shuffle (e.g. Tasman) and may be of specific interest to some acquirers.
Nortel emphasizes that its decision to file now, when its cash reserve is $2.6 billion, rather than 6-12 months down the line gives it added flexibility. That may be so, and may allow it to re-emerge as a smaller, better version of itself in the future. However, the scenarios mapped out above, in which rivals use Nortel's bankruptcy filing as a chance to reshuffle the supplier landscape dramatically to their benefit, seem more likely. While public credit markets are tight and investors cautious, more aggressive capital sitting on the sidelines may also see this as an opportunity too ripe to pass up.