Will This Deal Make Nortel the Intel of Optical?

Nortel's purchase of a key Swiss components plant could help make it the sector's key player -- if it finesses some potential problems

The deal was long rumored, but many analysts were surprised when Nortel Networks (NT ) finally went through with it. On Feb. 13, Nortel agreed to pay up to $3 billion in stock for JDS Uniphase's Zurich subsidiary, which includes one of only two factories in the world that produce a key component of the most advanced fiber-optic networks. The acquisition put Nortel, which is based in Brampton, Ont., in a powerful position in the red-hot optical-components market, where demand far outpaces supply. But it's also a position full of potential perils.

And it's a huge financial bet at a time when Nortel is retrenching. Citing an expected "severe economic downturn" in its U.S. market, the company announced on Feb. 15 that it plans to eliminate 10,000 of its 123,000 jobs, partly by selling off two other factories to contract manufacturers. It also slashed its earnings estimates, saying in this year's first quarter it now expects to lose 4 cents per share on revenues of $6.3 billion, a big drop from the 16 cents per share analysts had expected it to earn. For the full year, Nortel expects revenues to rise only by about 15% from last year's $30.3 billion level, vs. the 35%-or-so growth analysts had been expecting. Nortel shares plunged to under $30 on Feb. 14 as investors got wind of the impending announcement, a 52-week low and two-thirds less than they were trading at last July.

In buying the Zurich plant, Nortel is certainly gaining first-rate technological standing. The factory holds a 40% world share in the $387 million market for 980-nanometer pump-laser chips, the components needed to power certain kinds of fiber amplifiers that regenerate beams of light as they journey through hundreds of miles of optical cable. Owning the plant gives Nortel an array of competitive advantages, including uninterrupted supply of a key component at an advantageous insider's price.


  The purchase also is a significant step in the company's push to become the key player in optical components in much the same way Intel is synonymous with computer chips -- call it "Nortel Inside." The company already has an extensive components portfolio from its acquisitions of CoreTek and Photonic Technologies last year. Nortel's $2.4 billion optical-components unit, in fact, is its fastest-growing business. The trouble with this deal is that the Swiss facility's clients likely include Nortel archrivals Lucent Technologies, Cisco Systems, Juniper Networks, and Ciena, companies that may not want to rely on a competitor for a key component. Nortel, analysts fear, could lose key clients and end up having overpaid for a facility that serves only its internal needs.

To understand why that might happen, it's important to grasp just how competitive the optical industry is. Most companies in the industry don't make their supplier lists public. Players like Ciena have two to three suppliers they can go to for each component in case there's a problem with an order. Companies in the industry do sometimes buy parts from rivals. A Lucent microelectronics business, Agere, due for an initial public offering in March, is a supplier to Nortel, for instance. But out of fear of being left in the lurch, most companies try to avoid buying crucial, difficult-to-find components from their competitors.

Nortel will likely remain the Zurich plant's core customer, using an estimated 40% to 50% of the facility's output for its own needs. But holding on to the customers who buy the rest of the plant's products could be difficult long term, says Jim Andrew, vice-president at Adventis. That's because rivals may not want Nortel to be privy to their advance orders, which would allow it to judge the strength of their sales. In a business where systems and components companies often work closely together on developing next-generation products, Ciena or Lucent also won't want to share their product-introduction plans with Nortel. Plus, when components are in short supply, customers may worry that Nortel will fill its own orders first.


  But such worries could end up being set aside because the components in question are so scarce. The market for all types of pump lasers will grow at the compound-annual-growth rate of 40% from 2000 to 2004, when the market will reach $2.6 billion, according to the telecommunications consultancy RHK. The lasers are critical parts of photonic networks, a relatively inexpensive way to wring more capacity out of existing optical fiber.

The only alternative source of supply is JDS Uniphase (JDSU ), now that it has merged with SDL Inc. (SDLI ), the other major producer of the chips. JDSU, the biggest maker of parts for optical-communications networks, had to sell the Zurich plant to Nortel to assuage Justice Dept. antitrust concerns about the merger. "I don't anticipate that [Nortel] will gain or lose any customers," says Tony Muller, JDSU's chief operating officer. Not surprising, Nortel executives echo the sentiment. "In this industry, we sell to our competitors and buy from our competitors," says Barbara Callaghan, president of the components unit at Nortel. The company says it plans to make good on all of the plant's existing contracts.

In any case, the problem could be only temporary. Nortel's components division, which the plant will be a part of, could soon be spun off. Nortel executives haven't announced the plans yet but confirmed that an IPO is at the top of their list of options. That likely would make the unit more independent of the parent company's control.


  Aside from the risk of defections, the acquisition is probably a great buy in the short term -- and came at a good price for Nortel, according to TD Securities analyst Mark Lucey. On top of giving the company a foothold in Europe, the facility will provide considerable expertise in developing next-generation products. Nortel learned the benefits of building components in-house when it developed its OC 192 optical system -- and as a result, took a bite out of Lucent's market share last year, says Scotia Capital analyst Gus Papageorgiou. Contends Nortel's Callaghan: "This really accelerates our leadership."

If recent history is any indication, the plant also could shoot up in value. Originally a spin-off from IBM's research labs, the facility had just 50 employees when JDSU bought it from IBM in March, 1997, for $45 million. Today, it's going for about 66 times that and employs 400 (plus an eight-member support team in Poughkeepsie, N.Y.). As part of the sales agreement, Nortel agreed to hand over $2.5 billion in common shares on closing, as well as an estimated $500 million in common shares after Dec. 21, 2003, if it doesn't meet its purchasing commitments with JDSU. As part of the deal, Nortel agreed to buy more JDSU products.

Of course, one factory can't make Nortel a household name like Intel. But if Nortel can manage the risks, it could be a big step in that direction.

By Olga Kharif in New York

Edited by Thane Peterson

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