Will Cisco and Nortel draw closer? As an epic merger is debated, the facts justify a combined entity

America's Network, August 1, 2004 by Kaustubha Parkhi

The key to an enduring relationship is that both the partners should be compatible, or more precisely, willing to be compatible. Whatever drives that willingness is, as they say, totally incidental. It is easy to see why Cisco and Nortel have never crossed paths. There are clear reasons why each has reinforced its independence.

But circumstances and competitive realities change. Recent comments from Cisco CEO John Chambers have sent industry pundits off contemplating an interesting scenario: A Cisco-Nortel merger, acquisition or strategic alliance. Could it ever happen?

HISTORICAL PERSPECTIVE

Cisco's famed war chest has seen it acquire close to 70-plus companies during the last decade. Have a look at its acquisition pattern and observe the market opportunities that it has tried to address: SOHO, IP telephony, storage, enterprise conferencing, IDS, ethernet switching, VPN, metropolitan fiber networks, wireless networks, wireless LAN, Unified Messaging, broadband service management solutions, IP-enabled Storage Area Networking Technology, content aware switches, ATM and IP solutions, high-speed Silicon for terabit routers, software to manage information appliances, customer advocacy, media gateway technology, ATM Circuit Emulation Services (CES) Gateway, firewall, SONET and more.

On the other hand, Nortel has been more selective: managed carrier switches, content aware switches, ASP market, optical components, IP services, photonic switching, business consulting, front office solutions for E-business, network performance management, data networking, broadband networking and others.

One cannot help draw comparisons with the Sun-Microsoft saga. Replace Sun with Nortel and Microsoft with Cisco and many similarities come to the fore. Both Cisco and Microsoft are market leaders. Both Nortel and Sun have been challengers to Cisco and Microsoft's leadership on many fronts. Both factions in the story bear contrasting philosophies to their business approach and have been vehemently downplaying their competitors' points of view.

Nortel is predominantly a voice player that is adapting its to IP. For Cisco, IP is sacrosanct. Sun and Nortel are in bad financial shape, whereas Cisco and Microsoft are not. The market is crying for Nortel and Cisco's products to be compatible in the VoIP segment. A similar demand exists for Sun and Microsoft to be able to interface with each other on various fronts. The market may not be able to digest the thought of Microsoft acquiring Sun. It is a sentiment that many share about Cisco and Nortel.

NORTEL SINKING

The skeptics' argument holds water. In this case, the die seems to be cast predominantly in Nortel's favor. Look at how deeply troubled Nortel is: It has had to halve its reported earnings in 2003. It also needs to restate its earnings from 2001 onwards. And this is just the beginning. This explains the fact that after Chambers' statements, Cisco stock fell whereas Nortel stock rose. The market believes that Nortel has lot more to gain than Cisco.

It is important to remember that Cisco is always comfortable with acquiring smaller companies. It would itself prefer to acquire companies with a positive balance sheet. It has expressed as much publicly, although the fact of the matter is that it has not been always able to achieve this.

Moreover the cost of integrating the acquired company's product line with its own is something that cannot be overlooked. Analysts believes it might take up to two years for Cisco to fully integrate Nortel's products. And with Nortel's current precarious financial situation, the prospect is all the more daunting.

Adding to this is the market's inherent apprehension of big-ticket M&As. There is a general feeling that such M&As do not maximize shareholder value, unless the conditions are exceptional. One analyst wonders, "Why would Cisco want to dirty its hands?" This brings us back to our moot question: Are Nortel and Cisco willing to be compatible to bring about that exceptional condition?

SALES STRENGTHS

It is generally accepted that Nortel is more adept when it comes to carrier sales and Cisco reigns supreme when it comes to enterprise sales. Thus, there is a reasonable value add for Cisco. Remember, Cisco's valuation at current rates is roughly eight times that of Nortel. Gulping down competition never came so cheap. It is a bonanza for Cisco, as this partnership would make its mark felt in almost every slice of the telecom pie. As Anshu Dua of Pyramid Research puts it, "It would combine two of the leading wireline equipment manufactures and provide Cisco with a door to the cellular world via Nortel's CDMA and GSM product lines."

There is a not-so-hidden opportunity here. Carriers worldwide have been in belt-tightening mode for the last couple of years. The glut has affected Nortel badly with its revenue decreasing by more than 60% in the last three years, which in turn has depleted its valuation. By all accounts, the scene on the carrier front is all set to improve this year- round. Cisco would thus be in a strategic position to pick up a low- cost (not undervalued) stock that is likely to do well in the immediate future.