All Quiet on the M&A Front
By Jeanie Stokes
from the June 18, 2001 issue of Broadband Week
The big deal is on the back burner, at least for now, among U.S. telecommunications equipment makers.
A host of key factors is limiting merger and acquisition activity among the telecom equipment folks, even though some are as financially distressed as their counterparts in the services sector. While some investment bankers expect to see deals involving equipment makers pick up during the next year, they say future transactions are likely to be smaller and more strategically targeted than the mega-deals of the past.
The U.S. economic slowdown has stalled mergers and acquisition activity as well. Through June 11, total value of all U.S. transactions, fell 47 percent to $311.5 billion from $583.5 billion for the same period in 2000, according to Mergerstat. Telecom transactions accounted for just $4.6 billion of that total.
Declining stock prices have hurt the buying power of companies that like to buy other companies using their own stock as currency.
"The currency for M&A (mergers and acquisitions) is stock. If your stock price is high, you have great currency. When Cisco's stock price was high, they were buying a lot of companies," as many as 30 a year, says David Toung, telecom equipment analyst for investment banker McDonald Investments Inc. Now that Cisco's share price is lower, its acquisition activity has waned along with that of other equipment makers.
The ability to make a cash acquisition also is limited, even for well-capitalized companies, due to the capital markets' current lack of interest in telecom. Bond rating company Standard & Poor's Corp. lowered Lucent Technologies' credit rating to junk status last week and has warned it might cut Nortel Networks Corp.'s rating too, amid reports the company is considering selling off assets. Lower credit ratings raise the cost of borrowing money.
Outside the top tier companies like Nortel, Lucent Technologies and Ericsson, the telecommunications equipment sector tends to be financed through equity rather than debt. While start-ups in the telecom services arena are weighed down with huge amounts of high-interest debt, junk bond financing is rare on this side of the street.
"The fact that Lucent and Nortel have a lot of debt does not mean that the new equipment guys--the ones who could go bankrupt--have a lot of debt," says McDonald investment banker Brad Gevurtz. It's one reason why there have been so few bankruptcies among equipment makers. There are no debt holders waiting to be paid, and equity holders almost always lose out in a bankruptcy.
The newer service providers such as defunct DSL provider NorthPoint Communications, which filed for bankruptcy because it couldn't make debt payments, often see their assets sold for pennies on the dollar. A very different dynamic is at work in the equipment sector. When they get in trouble, they lose their people.
"On the equipment side, the value is intellectual power. It's the brainpower, the engineers and some of the patents that they have. Those are things that don't have value in a bankruptcy," says Toung.
Another factor limiting M&A may be the high valuations placed on many companies funded by venture capitalists in 1999. Those companies expected to be sold eventually to a major player like Cisco at inflated prices.
"Because of those high valuations, I think there's reluctance among sellers to accept the reality of the market," Gevurtz says. "There were a number of companies with zero revenue that VCs funded at $100 million valuation. As soon as the VC sells that company for $5 million, he's got a $95 million write down. My guess is, some of the little struggling ones are being told, 'Run lean, fire a few people and we'll give you a little money.'"
Many wireless businesses "have private equity backers who've tended to come in to support their companies. The wireless business continues to be attractive to the private equity market," says Christopher Coetzee, senior investment banker on Robert W. Baird's telecommunications and technology team.
Still, there is room for companies to buy and sell business units, even in today's tight money market.
Cisco remains "absolutely" interested in acquisitions. It's just not going to pay the premium that its targets were getting in the past, says Paul Hammer, head of the telecom group at investment banker Houlihan Lokey Howard & Zukin.
As the big equipment players like Nortel, Alcatel and Ericsson start looking at their core competencies, they're taking a hard look at which businesses they want to be in.
"We're seeing some M&A driven by divestitures," says Baird's Coetzee. "The divestiture opportunity by the major companies is creating some opportunity for the more focused players."
In one such sale announced this month, France's Alcatel agreed to sell its cable modem business to Thomson Multimedia for 9.5 million Alcatel shares. The deal gives Thomson a commanding stake in the cable modem worldwide market. Lucent also has been holding a highly publicized sale of its fiber optics business, although at press time still had not cut a deal.
In the past, acquisitions among equipment makers tended to be a large established company buying either new technology or research talent. Today's market constraints mean larger companies probably are going to do smaller transactions, Coetzee says. Smaller and midsize companies are looking for partners, whether they are combining through a merging of equals, or seeking a larger partner that can bring the financial and market muscle they need.
In May, TriQuint Semiconductor Inc. agreed to buy Sawtek Inc., a maker of filters for mobile handsets and wireless infrastructure, for stock valued at $1.3 billion. Even though Sawtek was nicely capitalized it found a stronger partner to help offset slowing business conditions, Coetzee says.
The wireless industry has sparked a good bit of investment interest among semiconductor companies such as Intel Corp., which is placing a major emphasis on the sector. The big players are looking for developed products created by companies that have good products, but no money to market them, says Hammer. He expects to see an increase in M&A activity in the coming months with companies being more creative to offset the lousy market conditions.
"Instead of buying it and saying, 'Here's a lot of cash. Go off and sail in Bermuda,' I think we'll see deals (in which) the earn-outs are more tied to the performance of the product. There will be more revenue-sharing arrangements, more creative rounds," Hammer says.
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