(Warning: Disturbing and potentially offensive analysis of the telco hardware business ahead — spanning four entire pages! Sedatives or perhaps stimulants may be needed, depending on whom you work for.)
On Wednesday morning, April 15, which has the distinction of being U.S. Federal Tax Day, the 105th day in the Gregorian Calendar, as well as the anniversay of the Battle of Formigny (1450), Alcatel-Lucent (NYSE: ALU), which was once part of a company based in New Jersey but is now based in France, announced it will now become part of Nokia (NYSE: NOK) in Finland.
The deal is valued at $16.5 billion. What do the hard-working folks and shareholders at Alcatel-Lucent get in exchange? They gain 0.55 shares of newly minted Nokia stock. Shares of both companies went down. Yes, just another day in telco land. And all very predictable. AlcaNokiaLunacy.
There’s a lot of breathless analysis being written about what this deal means (at least in one other blog, somewhere), but let’s face it: It’s a snoozer. A snoozer for losers. These companies — and their combination — represent a fraction of the value they once had. The deal has virtually no premium for Alcatel shareholders. It’s not creating value.
This is just another event in a long series of mergers reflecting a decaying business model in telco hardware. In 2005, I predicted that the future of the telecom equipment industry was consolidation and that most of the major telecom equipment vendors would eventually merge. And so it goes. We finally have Alcatel-Lucent-Nokia, after 10 years. This isn’t exactly Normenscatoni, but pretty damn close.
It’s hard to get excited about the future of a company whose DNA was partially derived from Murray Hill, N.J., by way of Boulogne-Billancourt and is now being shepherded off to Helsinki. The United Nations may have to start a telco equipment refugee program.
An Unfortunate Series of Disappointments
There are so many levels of disappointment, it’s hard to get started. But let’s start with the disappointment in the market. Those buying the Alcatel-Lucent stock on Tuesday on rumors about the deal ended up getting walloped. The stock popped about 20% Tuesday on speculation about the deal, but then plummeted 20% on Wednesday when the actual details came out.
Even though the deal was announced at $16.5 billion, while Alcatel-Lucent had a market cap of $12 billion, somehow Alcatel-Lucent stock fell 20%. Part of the reason behind the fuzzy math is that it involves an all-stock transaction in which Nokia issues new shares for the deal, diluting investors. Nokia will fire up the corporate printing press and buy ALU with 0.55 of each newly issued share for each Alcatel-Lucent share. Nokia shareholders will own two-thirds of the combined entity.
Got a headache yet? Me too. The bottom line is that it’s all monopoly money. There is no cash changing hands. It’s clear neither group of shareholders was enthralled with this fact, as Nokia shares on Wednesday fell 2%, to $7.84, on the news.
Both stocks went down. If that doesn’t reflect the disappointment, I don’t know what does. But disappointment is nothing new in the mega-telco-hardware space. Ask all those Lucent employees — and Rich McGinn and Carly Fiorina. Just as all the mergers before it, this will reduce jobs and slow down innovation as the companies convene armies of bean-counters to “rationalize” the business — a.k.a. take a chainsaw to functionaries and obscure departments.
We could get into the tactical elements: Nokia is now stronger by acquiring Alcatel-Lucent’s router business, possibly its strongest element. But as Simon Leopold, Managing Director of Raymond James, points out in a recent research note, the combination also re-establishes Nokia in the access business, which was apparently so painful that it decided to exit it two years ago by selling its broadband business to Adtran (another exciting telecom hardware company) and its optical systems to Coriant. Now it’s back in. So, Nokia gains routing and access and decreases its dependence on mobile networking, which will still be the bulk of its business.
Isn’t this all just moving food around the plate? Need I mention Nokia was once considered the telephone handset leader — but sold that business to Microsoft after being walloped by Apple and Samsung?
Where is the growth? Where’s the excitement over new technology?
What’s more interesting is what it says about the future of telecom technology in general. As disruptive technologies such as Software Defined Networking (SDN) and Network Functions Virtualization (NFV) come to market, there’s going to be even more pressure on the mega-hardware integrators, because software is a different business model. I don’t know that this merger changes that.
Post-Crash Merger Madness
The telecom equipment market, in a sense, is still trying to recover from the 2000 Internet and telco crash. It has experienced a long line of mergers that have been a zero-sum game — that is, when there is no growth, you attempt to roll up market share and reduce operational costs.
Just as an example, in March 2001 Lucent had a market cap of $44 billion, and Alcatel had a market capitalization of $45 billion. Keep in mind this was post-bubble-burst. In 2000 — prior to the crash — Lucent had a market cap of $252 billion! Nokia’s share price is currently 20% of what it was in 2000 and just 50% of what it was only five years ago!
Why the long, slow burn? Because the technology landscape has shifted to software in the cloud, and the business model of the old telecom-vendor landscape doesn’t work anymore.
The competitive dynamics are terrible. There is not much margin in the telco equipment business. You have a handful of gigantic buyers — the AT&T (NYSE: T), Verizon (NYSE: VZ), Deutsche Telekom (NYSE: DT), and Telefónicas of the world — with major leverage. In the end, the competitors in the telecom hardware business end up battling it out on price, and little more. The service providers pit the equipment RFPs against one another and brutally whittle down the price tag until there is no margin.
Witness these facts: Alcatel-Lucent’s profit margin over the last 12 months was 0.9%. Nokia’s was 27%. Nokia wins. Nokia gets to take Alcatel-Lucent. But the reality of the situation is that in 2012 Nokia had $20 billion in revenue, and last year it had $15 billion, after divesting Nokia Mobile to Microsoft. Alcatel-Lucent had $18 billion in revenue in 2012, which shrank to $16 billion in 2014.
The math is pretty simple. The combined Alcatel-Lucent and Nokia revenue in 2012 was $38 billion. If you combine their revenues in 2014 it was $31 billion. More shrinkage.
So will the merger work? Will the synergies pay off?
Leopold of Raymond James, in today’s note, doesn’t see a lot of extra upside.
“Consolidation may benefit the industry, but Nokia may face limited synergy opportunities,” he wrote.
Again, disappointment. Even the potential for squeezing a few extra pennies out of the “synergies” seems fairly dim. “…we see modest prospects for accretion,” writes Leopold. “Both firms have been restructuring for some time, so we see cost synergies as limited. A lack of product overlap limits opportunities in R&D. Much of the savings opportunity likely comes from corporate overhead.”
The Future’s So Bright, You Gotta Wear Software
Now, I hate to be bug in the bouillabaise. I still have some friends in this business, and I was sincere in my recent accolades for Alcatel-Lucent’s routing group and Basil Alwan. But that’s not the point. This is about corporate engineering, not innovation.
Instead, the telco giants should be investing where there’s growth: software and cloud. The telecom equipment behemoths appear to have missed every opportunity in the growth markets. The phone profits have accrued to the Apples and Samsungs of the world. The software profits have gone to the Googles, Facebooks, and Oracles. The service profits go to the service providers. Even over-the-top services such as Netflix and Skype have flourished, while the telco equipment sector limps along. You can blame Net Neutrality for some things, but not everything.
The answer is in the cloud: Flexible software and platforms fueled by the mega data centers growing all around us. The new architecture of modular software functionality riding on top of commodity hardware, known as Software Defined Networking (SDN) and Network Functions Virtualization (NFV). Container technology. Unified Communications. WebRTC. These are the exciting parts. Can’t they figure out how to make money on them?
It’s not about selling boxes any more. The business models of the telco box makers are about as fresh as a telephone switchboard. It’s about time to own up to that, or they’ll all just be merged down to nothing.
(Disclosure: The author is proud to say he owns none of these stocks, never has, and hasn’t even considered buying the shares since he told Lucent shareholders to get out of town in 2000.)