Many people in the telecom industry have been forecasting the consolidation of major equipment vendors at least since the bubble burst — and with increasing certainty as major IXCs announced plans to melt into the ILECs invading their traditional market. At the Fast Net Futures show in March, a panel of industry pundits agreed that large-scale vendor consolidation was the unavoidable consequence of mergers and slow-growing capital spending in the carrier space. But since then, major equipment vendors have defied these M&A marching orders, and many industry members now question whether the big vendors must consolidate at all.

In a recent report, UBS Investment Research said large-scale M&A in the infrastructure market, while possible in coming years, is unlikely in 2005. That conclusion was based partly on recent disappointing earnings from Siemens and partly on comments made in a second-quarter earnings call by Alcatel chief executive Serge Tchuruk, who said most major vendors want consolidation, but they want their competitors to go first and suffer the integration pains.

“Why should I pay for cleaning up the industry at my expense and leave the benefit for the other guys?” he asked. At the same time, Tchuruk challenged the notion that vendor megamergers are an eventuality. “I'm not really actively pursuing big consolidation as an indispensable way forward,” he said. “There are ways you can go which are not massive consolidation between giants, which can also help. … Hopefully, you'll see a few of those things happening.”

John Chambers, CEO of Cisco Systems, which has been linked in M&A rumors to everyone from Nortel Networks to Nokia, aimed to end such speculation once and for all in his company's earnings call last week. Though Cisco is famous for absorbing countless start-ups, “We're extremely unlikely to ever do a large acquisition,” he said. “In my view, most all of them fail.”

The past two years have seen several acquisitions of smaller vendors. Just last week, CDMA innovator Qualcomm agreed to acquire OFDM developer Flarion Technologies,.

But there has yet to be a deal between two big vendors. “Most of the activity has been what I'd call consolidation that doesn't make a difference,” said Dana Cooperson, Ovum-RHK analyst. “[Vendors] trying to beef up their own product line but not taking a competitor out of the market in any meaningful way.”

To proponents of vendor megamergers, the handwriting is on the wall. Equipment sector gross margins, once in the high 40s, are now in the high 20s or worse, a problem exacerbated by cutthroat prices from Chinese vendors. Global carrier capex will grow less than 8% this year before flattening out in 2006, UBS predicts, and the 8% growth seen in the equipment space this year will shrink to 4% next year. “It's very clear equipment manufacturers need to consolidate,” said Ragu Gurumurthy, senior vice president at consultancy Adventis, though he admits major M&A isn't likely to occur in the next year and a half.

There are countless non-strategic, even non-financial, barriers to big M&A, of course. Nationalism alone might shield vendors such as Nortel, Alcatel and Ericsson — so strongly identified with their home countries — from foreign acquirers. (That sentiment doesn't seem to apply to U.S. firms, however.) Lucent Technologies' pension liabilities could haunt M&A prospects, having reportedly weighed like an anchor on its storied near-miss merger attempt with Alcatel in 2001. Then there's the challenge of merging corporate cultures. A year ago, Cisco and Nortel were rumored to be in merger talks, but the abrupt departure of two former Cisco executives from Nortel recently over “divergent management styles” raises questions about the threat of culture clashes to any future mergers.

The notion that carrier consolidation inexorably leads to vendor consolidation is a matter of some debate. Some believe merging carriers are likely to stick with their chosen suppliers and retain their pre-merger multi-vendor environments. Carriers, which have long expressed the desire to work with fewer vendors, may simply do so rather than wait for their suppliers to consolidate. Just as SBC Communications deputized Alcatel to lead its Project Lightspeed broadband buildout, carriers may increasingly pick a small list of vendors to work with and allow them to subcontract to others.

“I'm not sure what rationale suggests that just because carriers are consolidating, equipment vendors should as well,” said Eric Buck, financial analyst at Janco Partners. “What's driving the market isn't the number of carriers, it's the amount of traffic going over the network. Whether its 1000 customers or 500 customers, the equipment requirement is going to be essentially the same.”

But, giant-size M&A may get moving “if we see distinct winners and losers among vendors,” UBS wrote. In one instance, the loss of a single contract was enough for a major vendor to throw in the towel. Only four months after Marconi was passed over for a piece of BT's multibillion-dollar “21st Century” initiative, the company admitted it had begun discussions of a possible acquisition by Huawei Technologies, which won two pieces of the big BT job.

Vendors with about 10% of any given market have some breathing room, as do small, focused vendors gaining share, such as ECI Telecom and Adva Optical Networking. Vendors with 7% or so declining market share are more vulnerable. “There's a bunch of guys in the middle that need to decide what they want to do,” Cooperson said. “They're not making headway.”

In the near term, vendors are likely to take even harder looks at their product lines, decide which businesses they want to keep and shed the others, relying on partners to fill those gaps. Vendors have been partnering for years to add to product portfolios, but they may increasingly replace their own products with partnerships, allowing them to cut down on R&D expenses and boost margins.

Earlier this year, Nortel chief executive Bill Owens voiced plans to partner with smaller Asian firms to help Nortel compete with large Chinese vendors. And after sales of Nortel's UMTS and GSM wireless gear flattened in the second quarter, Owens vowed to find partners to help in that space, too.

Vendors may look to Juniper Networks' partnership with Lucent as a model of success. In the first full year of that partnership, 2004, at least 10% of Juniper's total revenue came through Lucent. However, that success isn't easy to copy. Nortel's own partnership with router vendor Avici Systems, for example, hasn't been nearly as fruitful. Cooperson attributes the success of Lucent/Juniper to the complementary nature of each company's technology and customer base — a dynamic others should try to emulate, she said.

Going forward, vendors may find that, although partnerships may not be fraught with as much complexity as megamergers, they also can be difficult to manage. “There are not a lot of examples of strong partnerships that resulted in satisfaction on the side of both parties,” Owens admitted in Nortel's second-quarter earnings call. But, he added, “It is a new world. Partnering has to be a very strong part of it.”

Major telecom equipment vendors' 2004 sales
in billions of dollars

Huawei — 4.3

Fujitsu — 3.3

Ericsson — 3.2

ZTE — 2.9

Cisco — 2.8

UTSI — 1.9

Marconi — 1.7

Telllabs — 1.2

Juniper — 1.2

Samsung — 1.1

ADC — 0.8

China Putian — 0.8

ECI — 0.5

Source: OVum-RHK

Vendor M&A activity in 2005

ACQUIRER	ACQUIREE	PRICE ($M)	DATE
Alcatel	Native Networks	55	March '05
Juniper Networks	Kagoor Networks	68	March '05
Siemens	Myrio	50	April '05
Cisco Systems	Topspin Communications	250	April '05
Nortel Networks	PEC Solutions	448	April '05
Juniper Networks	Peribit Networks	337	April '05
Juniper Networks	Redline Networks	132	April '05
ECI Telecom	Laurel Networks	88	May '05
Ericsson	Axxessit	51	June '05
Zhone	Paradyne	180	July '05
ADC	FONS	172	July '05
Source: UBS Investment Research