Lucent-Alcatel: A Marriage of Equals?

In the battered telecom-equipment sector, this combo could work -- though some analysts expect Alcatel to grab the upper hand

Less than a decade ago, some of the biggest movers and shakers in tech were companies that made the gear at the center of telecommunications networks -- the switches, routers, and other devices at the network's core that transfer massive amounts of data across the Internet in the blink of an eye.

The latest reminder of how much those times have changed came on Mar. 23, with the disclosure of merger talks between telecom equipment giants Lucent Technologies (LU) and Alcatel (ALA). Make no mistake. Switches and routers and other telecom gear still matter. But their makers don't command anywhere near the premium that they did just a few years ago.

These days, the real action is at the part of the network closer to the end user, the so-called edge, where innovative application developers like Google (GOOG) are amassing power (see BW Online, 11/18/05, "Is Google Flying Too High?").


  Lucent and Alcatel said in a Mar. 23 statement that they were in talks that could lead to a deal at market value. That means the combined merger would be worth about $33 billion, based on that day's valuations of $12.5 billion for Lucent and $20 billion for Alcatel. Internet giant Google, which is moving into telecom services over the Web, has a market cap of $108 billion, more than three times the combined value of the would-be partners.

Six years ago, Lucent and Alcatel had massive market caps, and Google was a tiny Internet search engine based in Mountain View, Calif. Lucent once was worth in excess of $100 billion and an adjusted share price of more than $60. It closed on Mar. 24 at $3.06, and that was after an 8.5% boost of 24 cents on news of the talks. Shares of Alcatel rose 17 cents, or 1.1%, to $15.62.

Telecom equipment has been one of the longest- and hardest-suffering areas of tech. In their heyday, telecom equipment makers like Lucent, Alcatel, and Nortel (NT) made the rules for the entire sector. They established proprietary standards, controlled the pace of innovation and change, and even dictated when big customers could roll out new products such as Caller ID.


  The Internet changed all that. The communications industry is adopting open standards based on the Web. And even though big telecom switches may still be based on proprietary standards, it's easy for an application developer to navigate that problem.

Google, Yahoo! (YHOO), AOL (TWX) and eBay (EBAY), owner of Web phone sensation Skype, all offer voice-based messaging services that are accessible from any Web browser. As a result, the role and value of big equipment manufacturers focused on the core of the network has been overshadowed by application developers at the edge.

The equipment manufacturers won't go away. Applications are nothing if they don't have a network to run on. But companies like Lucent and Alcatel have had a rough adjustment to the new reality. They have spent years cutting costs, shedding unprofitable businesses, and building up their product portfolios in gear designed to move Internet traffic. Now they are trying to combine forces to become even more efficient.

They follow big customers such as AT&T (T) and Verizon (VZ), which have been consolidating for years. In March, AT&T announced that it was buying BellSouth, in the latest sign of consolidation in the services side of telecom.

A Lucent-Alcatel merger will help both, although it won't be a panacea for either. Lucent is strong in wireless infrastructure and has lots of big customers in the U.S. Alcatel has forged a name for itself in wired broadband networks, fiber optics, and TV-over-Internet gear. But it wants to be bigger in the U.S., even though it's already a major supplier to AT&T and others.

"A deal would give Alcatel customers and technology where it needs them," says Susan Kalla, a telecom analyst at Caris & Co.


  Lucent management has done a good job of getting its cost structure and finances in order during the tenure of chief financial officer Frank D'Amelio. But CEO Pat Russo has had a rough job. After the tech bubble burst, she only had enough money to focus on a few sectors. She chose wireless and services, which were reasonable choices. But as Kalla notes, wireless spending is subject to peaks and troughs.

AT&T and Verizon have spent a lot upgrading their wireless networks and are shifting capital spending to other areas, such as TV over fiber-optic lines. Given the nature of the market, it makes more sense to combine the resources of several large companies into one huge player. If Alcatel executives get the upper hand in running the enlarged company, "it would give Lucent management a graceful exit," Kalla notes.

Lucent and Alcatel confirmed that they are in talks but cautioned that a deal might not occur. They described the talks as leading to a possible "merger of equals." An acquisition by Alcatel is the more likely structure, Kalla notes. "Merger of equals," Kalla says. "What a joke."


  The two companies tried to combine in 2001, but the talks fell apart because of internal power struggles. Those hurdles may be put aside now, because Alcatel is now far stronger and Lucent's fortunes recently took a turn for the worse (see BW Online, 1/17/06, "Darkness Creeps Over Lucent").

National political concerns aren't likely to block a deal. A merger would be subject to review by the Committee on Foreign Investments in the U.S., which includes representatives of the Treasury Dept. and other executive branches of government. There was a furor recently over the prospect of a Dubai-based investor controlling U.S. ports.

But an Alcatel deal may have an easier go, analysts say. "I don't think any concerns will be significant enough to block a deal," says Blair Levin, a telecom regulation analyst with Stifel Nicolaus Associates.


  A deal won't solve all of the considerable challenges for either company. Some analysts even question whether it's worth the trouble for Alcatel, which already has a significant business in the U.S. and operates all over the world.

Richard Windsor, a telecom equipment analyst with Nomura Securities, says Lucent has some great assets, and that Alcatel would benefit from them. He would prefer to see Alcatel simply purchase the assets it needs and leave the rest. But that would leave a huge mess for Lucent's management, making such a transaction hard to pull off.

It appears that the long awaited consolidation of the telecom equipment sector is just getting under way. A deal between Lucent and Alcatel is likely, and that means that rivals such as Motorola (MOT) and Ericsson (ERICY) may be on the hunt.

There are plenty of targets to choose from, such as hobbled giants like Nortel (NT) and smaller companies like broadband equipment maker Redback (RBAK)(see BW Online, 10/18/05, "Can an Ironman Remake Nortel?") . Given the changes in the sector, there are simply too many equipment makers to survive on their own.

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