Some Win, Some Lose in the Acquiring Game - Industry Trend or Event

Lucent and other companies have discovered that billion-dollar telecom mergers don't always work out as planned.

NOT TOO LONG AGO, TELECOMMUNIcations companies were built mostly through basic in-house research. These days, however, telcos are scaling back research, depending instead on multibillion-dollar acquisitions to foster new technology and fuel growth. They may be setting themselves up for a fall.

Last year, Lucent acquired Internet-equipment maker Ascend for $24 billion. San Jose, Calif.-based JDS Uniphase, which makes parts for optical-network equipment, announced two weeks ago that it would pay $41 billion for rival SDL. Last week Corning was reportedly in talks to buy Nortel's optical components business for $100 billion. While the prices for such acquisitions spiral out of sight, the benefits are not always evident.

Some high-profile companies with massive market caps have gone after unproven startups or competitors. Lucent's $4.6 billion buyout last month of optical networker Chromatis, which had generated zero revenue in its short life, and Nortel's $6 billion acquisition of no-income Xros, announced in March, are two of the most striking examples.

"We're obsessed with startups," admits Vivian Hudson, a VP at Nortel. "We're all trying to solve the same problems, and we know the most clever answer won't always come from Nortel."

Often these billion-dollar mergers carry hidden or ignored costs. To acquire SDL, JDS Uniphase agreed to pay roughly 100 times what SDL is expected to generate in revenue in the coming year. That cost could cramp JDS' income statement for perhaps five years. JDS is already on a five-year amortizing schedule for its $18 billion acquisition of San Jose, Calif.-based E-Tek this year, another optical-networking-parts maker.

While SDL's technology is a boon to the optical networking industry, there's little reason to think that rivals like Nortel and Lucent - or an as-yet-unknown startup - won't come up with something better. But as long as Wall Street seems to accept such nagging costs, this type of accounting will stay popular.

Some companies thrive on acquisitions: Cisco, for example, has bought its way into new markets for years. But mergers alone won't propel companies to greatness. Nortel has dominated optical networking thanks to its engineering foresight in standardizing on faster optical standards. Sunnyvale, Calif.-based Juniper made its name by building a new class of routers from the ground up, while Sycamore of Chelmsford, Mass., has won big deals by being first to market with ingenious new optical-networking gear.

Even successful mergers don't always pay off in measurable ways. The Lucent-Ascend megamerger has made Lucent a force in data networking. But it hasn't stopped the company from delivering disappointing earnings reports for two consecutive quarters. In December, Lucent warned that its quarterly profits had fallen 23 percent, triggering a 28 percent drop in the company's stock. Lucent lost $64 billion in market capitalization that day. Two weeks ago, the company reported it had beat earnings estimates, but said revenues will fall off next quarter. Again Wall Street punished its stock.

In acquiring Ascend, Lucent faced one problem chronic to highly visible mergers: retaining talent. After Lucent took over, top executives at Ascend promptly secured jobs elsewhere. "We all had opportunities outside of Lucent," says Sam Mathan, former VP at Ascend, now CEO of telecom startup Amber Networks. "For me personally, I like to build things. I belong at a startup, not a big company."

According to Lucent execs, the division that includes the former Ascend business accounts for roughly $4 billion in revenue a year. Since the acquisition, Lucent has taken Stinger, a new piece of digital-subscriber-line equipment built by Ascend, and gone from no market share to the fastest-growing supplier of DSL equipment, second only to Alcatel. The deal also gave Lucent a long customer list of Internet service providers and data networkers.

"Quite simply, Lucent did not have a real data networking strategy until the Ascend deal," says Joe Sigrest, president of access products at Lucent and a former Ascend employee. "But more important, once they got Ascend, Lucent has taken that business and built it into something [Ascend] couldn't have become if they had gone it alone."

But if the acquisition was good for the company's Internet strategy, Lucent has still been slow to move into more explosive businesses like optical networking. Considering that Lucent grew out of the venerable Bell Labs when it was spun off from Ma Bell in 1996, that's a disappointing lapse.

Scientists at Bell Labs have come up with some interesting innovations in recent years -- like using mirrors to route signals at several times the speed of traditional switches -- but Lucent has been slow to turn those innovations into marketable products. For example, the company has failed to develop 10-gigabyte optical-transport equipment -- which archrival Nortel has been selling for four years.

"In the past, research has come up with something neat, but when we toss it over the fence to development people, they're not always there to pick it up," says Wayne Knox, director of advanced photonics research at Bell Labs. "Startups have always been good at picking up and running with research because they're focused on one thing. We're working to make sure that research makes it all the way through to development."

To right his listing ship, Lucent CEO Richard McGinn has been spinning off divisions faster than he acquires new ones. The company plans to spin off its microelectronics unit in an IPO early next year, following announcements that it would shed its power systems unit and its slow-growing office network business. But spinoffs and acquisitions like Ascend will not be enough to save McGinn's job. The brainpower at Bell Labs will have to once again produce winners.

"Traditional research has its place, but it's much smaller now' says Marek Wernik, director of disruptive market and business solutions at Nortel. "We prefer to look to partnerships with venture capitalists or other relationships to look for partners or potential companies to acquire. That's a much more reliable route to get new technology."

How long will devaluation of traditional research in favor of quick fixes through acquisitions last? Perhaps at some point Wall Street's hunger for all things telecommunications-related will abate, and companies will depend less on mergers and acquisitions to help them expand. But for now, acquisitions and creative accounting are just too easy a path to growth.

As long as a few giants can buy out their rivals -- and Wall Street goes along -- that attitude will prevail.

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