Nortel Networks Corp. has a problem.
What should the telecom-equipment maker do now that talks on the sale of its optical-components unit to Corning Inc. have broken down?
Facing stiff competition from rival telecom-equipment OEMs, the combination of Nortel's optical-components business with Corning's seemed like a sure-fire solution to Nortel's components-supply constraints. It also seemed like a natural step, considering the long partnership between them.
With the breakdown of those discussions, however, Nortel now must choose between injecting funds into the optical-components business to meet surging demand or spinning off the unit in a last-ditch move. Both moves have significant implications for the optical-components market.
A spinoff means the Nortel unit will be able to raise enough funds to match the deep pockets of rival suppliers like JDS Uniphase Corp. By keeping the unit, however, Nortel may be forced to patronize its current suppliers like Corning and JDS Uniphase even more if it is unable to furnish expansion capital.
Nortel may be in the same boat as Lucent Technologies Inc., Murray Hill, N.J., which plans to spin off its microelectronics unit, a maker of communication ICs and optical components. Nortel's choices may be limited by the increasing realization that the era of the vertically integrated OEM is all but over, analysts said.
"The move toward increasing optical content within any communications network and outsourcing optical components to merchant manufacturers is likely to substantially boost the growth rates for pure-play optical-component vendors," said Arun Veerappan, an analyst at Robertson Stephens Inc., San Francisco.
In the last year, Nortel jacked up its optical capacity sixfold in an attempt to eliminate components shortages and satisfy strong demand for its networking equipment from telecom and datacom companies. Recently, the company announced plans to spend $1.9 billion to strengthen its optical operations, with $1.2 billion going to the optical-components business.
"The investment highlights the value of Nortel's optical-components business above and beyond its support of Nortel's optical-systems revenue," said Paul Silverstein, an analyst at Robertson Stephens.
According to Nortel estimates, revenue at the optical unit will grow 250% this year, to $2.5 billion, with more than 80% of the output going to the parent company.
As it ponders its next move, Nortel is showing no sign of easing up on its acquisition strategy. The company late last week agreed to pay about $7.2 billion for Web switch develop Alteon WebSystems Inc., San Jose.
The all-stock deal would allow Nortel to build next-generation Internet data centers -- massive compounds of powerful communications gear such as servers, routers and storage -- that are used to host Web sites or applications that run Internet commerce, trading and businesses, according to the Reuters news service.
Nortel said the deal positions it to integrate Internet data centers with high-speed optical and third-generation wireless networks, Reuters reported.
Meanwhile, Nortel is increasingly having to source components from pure-play optical-components suppliers like New York-based Corning, JDS Uniphase, and Lucent's soon-to-be-independent microelectronics group. In the quarter ended March 31, JDS Uniphase said Nortel and Lucent accounted for 38% of its $394.6 million in revenue.
Nortel is competing for components with major telecom-equipment OEMs and smaller players like Corvis, ONI, and Sycamore, which have been attracted to the market's double-digit growth rate.
Had it been successful, the Nortel-Corning alliance would have created an optical-components behemoth with sales dwarfing those of JDS Uniphase and Lucent's optical-components business combined. The combined entity would be able to fund much-needed technological innovations, acquire start-ups with relevant intellectual property, and construct larger manufacturing plants.
The same high valuation that Wall Street has given companies like JDS Uniphase, Nepean, Ontario, stood in the way of the transaction. Nortel and Corning were unable to reach an agreement on the terms of the deal and which entity would retain control.
The $100 billion figure for the Nortel unit bandied about by analysts was unacceptable to Corning because it would give the Canadian company majority control of the entity. Corning executives said the company was not prepared to yield on this point.
So which option will Nortel pursue now that this proposed alliance has unraveled? The company appears unwilling to spin off its optical-components business despite the promise of new equity funds that could alleviate the capacity crunch facing the business.
There's at least one reason for this position. Nortel's optical-networking-equipment business is the company's fastest-growing. Anchoring its growth is the optical-components business. Though capacity-constrained, the unit has been growing at double the rate of the entire company.
"We have one of the largest and fastest- growing optical-components businesses in the industry," said John Roth, president and chief executive of Nortel. "We intend to continue to invest in and strengthen this business to provide the strategic support for our optical Internet business, which grew in excess of 150% in the second quarter of 2000, compared with the same period last year."
Nortel is sitting on a pile of cash that can be used to finance expansion in its core equipment business, analysts said.
"Should Nortel seek to monetize this business through either a spinoff or outright sale, it potentially could realize $100 billion or more [in excess of $30 per share], a valuation that's not currently reflected in Nortel's share price," Robertson Stephens' Silverstein said.
With the enormous valuation its optical-components business can command on Wall Street, Nortel may be compelled to spin off the unit in an initial public offering.
Under such a scenario, which would be slightly different from Lucent's approach, Nortel would retain some control over the optical-components business to guarantee access to its products, analysts said.
In the wake of Lucent's planned spinoff, Nortel isn't the only one exploring options for its optical-components business. Alcatel's board has approved plans to create a new class of Alcatel stock intended to track the performance of the company's Optronics Division, which makes optical components.
Executives at the French company said they believe creating a tracking stock will enhance market recognition of the Optronics Division's value and increase Alcatel's ability to respond to opportunities in the optical industry.