The little deals matter

October 18, 2004

3 Min Read
M&A Mojo

Whatever happened to Normenscatoni? (See Introducing... Normenscatoni! )

Good question. About a year ago, I argued that consolidation in the telecom equipment market could eventually take the form of megamergers that could create such strange bedfellows as Cisco Systems Inc. (Nasdaq: CSCO) and Lucent Technologies Inc. (NYSE: LU) (Cisclu), or Nortel Networks Ltd. (NYSE/Toronto: NT), Alcatel SA (NYSE: ALA; Paris: CGEP:PA), and Marconi Corp. plc (Nasdaq: MRCIY; London: MONI) (Normenscatoni).

It didn't happen.

That is, the megamergers haven't happened yet. Instead, the M&A market has focused on small and midsized deals in which larger companies seek growth in new markets, looking to acquire the right products.

Hence we've had such deals as Juniper Networks Inc. (Nasdaq: JNPR) buying IP VPN and security specialist NetScreen and Tellabs Inc. (Nasdaq: TLAB; Frankfurt: BTLA) proposing to buy Advanced Fibre Communications Inc. (AFC) (Nasdaq: AFCI) – although, as documented on Light Reading, that soap opera of a deal has yet to close.

This is healthy activity, and it shows how markets have a self-correcting mechanism to reduce the number of companies after unnatural numbers of them blossom in bubble-like phases. It's capitalism's version of Darwinism.

Another driving force that will keep the M&A market moving is that service providers have solid, real-world demand for emerging technology. It's clear that as hot new enabling technologies for VOIP and triple play take hold, some equipment vendors have been caught flat-footed. That doesn't change service provider needs -- they still want the stuff, but they want to buy it from an incumbent.

When service providers feel they can't get that next-generation technology from their incumbent equipment supplier, they're asking those suppliers to go out and find it. We've seen this in deals such as Ciena Corp.'s (Nasdaq: CIEN) acquisition of WaveSmith and Tellabs's pending merger with AFC.

So who's likely to benefit from this trend? Well, the companies that have put their chips on the right technology markets. Areas such as softswitching and traffic management are particularly hot.

This month's Light Reading Insider, M&A: Consolidation Craze, examines these M&A trends and comes to a few conclusions. First of all, the current pace and character of M&A activity is likely to continue, as valuations have stabilized and folks have a better sense of what companies are "worth." In most cases, we've returned to rational valuations, in which companies are valued at two to five times sales or carry P/Es in the mid teens and twenties, rather than the more absurd valuations of the bubble days. Those companies with premium valuations, such as Cisco and Juniper, will continue to use their stock to acquire companies.

This month's Insider also identifies the key technology "hot spots" in which larger companies are looking to acquire, and it also names some of the leading candidates for such acquisitions. Some startups may even be positioned well enough in these key markets that they could launch IPOs in 2005.

While the slow and somewhat arduous pace of the current merger market seems subdued compared to the orgy of activity in the 90s, it's a healthy and reasonable process.

The number of competitors needs to be further reduced to improve profitability and return the industry to growth. In many cases, you'll see multiple vendors beating each other up on pricing in key service provider RFPs. In the end, fewer companies will mean more stable pricing and eventually better margins.

And what of the megamergers? In the end, all the trends still point towards them. But it now looks like we may have to wait another few years for Normenscatoni.

— R. Scott Raynovich, US Editor, Light Reading

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