Is the fair value of Nortel's metro Ethernet and 40Gig product line only $600 million?

Because it's not a turn-around expert, Cisco won't be expected to bid.

I want to share with you a research note that I received earlier this week from RBC Capital Markets Managing Director - Mark Sue in regard to the sale prospects of Nortel's Metro Ethernet unit, "Incomplete information, escalation of commitment, and overconfidence can easily lead to the winner's curse when it comes to the optical asset purchase of the now defunct Nortel. It seems everyone wants it, they all know that the other parties want it as well, so how do they avoid overpaying? It just takes one unreasonable person to overestimate the metro Ethernet and 40Gig product line and its future value and the price tag of the deal can easily escalate to $1B, far above our fair value estimate of $600M. "Nortel's Metro Ethernet Networks includes the bulk of Nortel's optical assets and was on an annual revenue run rate of $1.2B while teetering around break even. Alcatel Lucent, Ciena, Cisco, Ericsson, Fujitsu, Huawei, Infinera, Juniper, Nokia Siemens, and Tellabs may all be sniffing around the assets. Nortel's products are good, the customer base is strong, and for some of the smaller companies, it can triple the size of their revenues overnight. But there are concerns as well: the business never generated meaningful cash from operations, some segments are price sensitive, the revenue outlook for this year is probably closer to $1.0B or less, and Nortel successfully upset numerous carrier customers along the way."

Nortel's Metro Ethernet Solutions Sue continued, "Who does it makes sense for? We're not sure the optical products fit well into Alcatel Lucent, and the new CEO may rather be focused on his new 'strategic initiative' than restructuring and integrating a large organization. And the last time Alcatel Lucent acquired Nortel's assets, it ended pretty badly. Ericsson just spent a lot of money ($1.13B) for the wireless assets and since they have a 40G solution of their own, it seems to us they would not be interested. Cisco has the biggest boatload of cash ($35B) yet our contacts are keen to remind us that Cisco is not a 'turn-around' expert. "Tellabs just announced a $200M stock repurchase so that might be their wallet opening event for a while. What about Juniper? We think that someone will end up burned at the stake considering the company's mixed tracked record with acquisitions. Infinera? Pairing up with a sponsor might help yet the private equity investors need some light at the end of the tunnel, and the optical market if anything will likely get even more competitive over time. Buying someone else's 40G as you develop your own 40G doesn't make sense either." Nortel Metro Ethernet Services Unit Deployment Options Sue added, "So the key vendors which understand the perceived value proposition and have the willingness to pay may be Huawei, Nokia Siemens, Fujitsu, and Ciena. Huawei, could make sense, yet for some reason, they are considered more 'foreign' than the other foreigners, and the prospects of carrying 'government sensitive' traffic may be tough to get approved. Nokia Siemens has $650M lying around and might still be sore after losing out to Ericsson on the wireless bid yet, we're not sure winning something is a win for Nokia Siemens; where's the synergy? Fujitsu and Ciena make the most sense to us. By the way, please don't bring up Sycamore. Fujitsu can bulk up its market share while Ciena gains a stop gap product line until their 100G optical product gains more meaningful traction. "So if you're Ciena (Nasdaq: CIEN; $12.52; Outperform, Speculative Risk) how do you get a deal done without paying more than $600M? Particularly if you have $1.2B in cash yet $800M in debt and you'll need some cash to run the acquired business unit. And what's the basis for the valuation? What are the larger considerations for Ciena to consider? Is there time value assigned to the optical assets?" Nortel Adaptive All Optical Intelligent Network Sue expounded further, "In our view, Ciena has to seriously consider its best alternative to a negotiated agreement. Ciena will be fine in our view without making the acquisition and the integration challenges are no small matter. Yes there are benefits to the deal yet there are costs as well. A simple multiple of sales can lead to a value, but remember the optical market may shrink this year before recovering next year. The big picture consideration includes the feedback from core customers such as Verizon, AT&T, Qwest, and Sprint. Remember BT never really liked Nortel's products. Ciena needs to do the analysis for themselves but more importantly for the other side and their competitors as well. "Other points to consider: If there is no deal, how can Ciena otherwise get to 40G and round off some other Metro Ethernet products? And how does Ciena value all the benefits and costs of their fallback plan, now and later? How will Fujitsu and even Nokia Siemens respond to Ciena's bid? What is the decision of the other bidder? We've seen it before with several tech deals this year and most tend to escalate their commitment to a previous course of action. Basically, justifying the mess they get themselves into." Nortel Optical Networks Portfolio Sue concluded, "Ciena can expand the opportunity by considering what Nortel wants. In our view, it's not just the highest bid. It might serve Ciena well by messaging the intentions of acquiring the assets, the commitment to optical market (past and future) and providing some assurance that the employees will be taken care of. Look at the RIMM situation where they were blocked from bidding as an example. There's perceived value in expanding the scope of their intentions and providing some clarity that the customer and the bulk of the employees will be regarded; in our view, Ciena might be wise to assign a price to it. "What's the setup to avoid? Ciena bids $400M, it escalates to $650M, and someone comes in at the last minute and offers $1B. In a bankruptcy restructuring, agents just want the deal to close. In our view, Ciena doesn't have to play passively with the rules that have been given. It could change the process as needed to get to a better outcome. We believe Ciena can make multiple offers simultaneously not just on price and also search for post settlement settlements which can lock in the deal. Good luck and let's not win something for the sake of winning."


What's your take, do agree with Mark Sue that the fair value of Nortel's metro Ethernet and 40Gig product line is only $600 million?

BradReese.Com Cisco Refurbished - Services that protect, maintain and optimize Cisco hardware Contact: Brad Reese | Twitter: http://twitter.com/BradReese

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