Nokia on edge of precipice, confirming ALU talks April 14 2015

BY CAROLINE GABRIEL

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The rumor that Nokia and Alcatel-Lucent would merge has come around many times in recent years, but the story hasn't got any more attractive with repetition. But now it is real, with Nokia confirming reports that it is in "advanced discussions with respect to a potential full combination" with its French rival.

Nokia said any deal "would take the form of a public exchange offer by Nokia for Alcatel-Lucent". The Finnish company currently has a market capitalisation of €29bn, and ALU's is €11bn. Analysts estimate that ALU could be worth €4.50 a share, or a total of €12.7bn ($13.4bn).

Of course, a deal would give the enlarged Nokia the scale that may be required to stay ahead in the pressurized telecoms equipment market. But it will also create massive integration challenges which could distract the new entity for a couple of years during a time of critical transition among carriers, in particular towards software-defined networking (SDN).

In the early stages of that new phase, Nokia looks well positioned in terms of product offering and philosophy. There seemed to be a real strategic option to move gradually away from the rapidly commoditizing hardware businesses, relying on partners for those (as it has already done in some areas like microwave backhaul and WiFi), and become a leader in carrier software - a smaller company, but a profitable one focused on the key area of investment for service providers in the later years of the decade.

But Nokia seems determined to cast off its long history of radical reinvention and cling to the 'size is all' mantra which has recently driven the network equipment sector. Combining with Alcatel-Lucent would give it combined revenues of €26bn, based on last year's performance, just ahead of Ericsson's €24.4bn.

It would see Nokia abandoning the strategy which has finally brought it to the brink of turnaround - doubling down on mobile broadband alone - since it will take on ALU's significant wireline business.

The mobile-only approach has seen the Finnish firm sell off its devices business (and possibly, according to other reports this week, its Here mapping unit). The refocus has also seen it divest many non-core businesses, as well as invest in smaller firms with technologies that will be important for the two dominant mobile growth drivers - SDN/virtualization and '5G'. Nokia has been prominent in the early development of both, moving early into software-driven network platforms under its Liquid banner, and demonstrating R&D breakthroughs in anticipated 5G approaches such as millimeter wave spectrum and massive MIMO.

The decision to sacrifice size and some revenues for profits and differentiation has brought Nokia close to recovery after years of losses and serial restructurings. Just at the moment when CEO Rajeev Suri might claim tentative victory, he seems set to throw it all away. Yes, ALU would bring Nokia greater scale to withstand the economics of Ericsson and Huawei; and most importantly it would bring the French firm's most impressive product line, its core and edge routers. That would enable Nokia to go after a wider range of service providers, as Ericsson is doing, and - importantly - to target the rising tide of convergence between MNOs and wireline operators, offering a complete portfolio without relying on partners.

But the risks and downsides are daunting. Nowhere will Oscar Wilde's aphorism, that second marriages are the triumph of hope over experience, be more apt. Both the would-be partners have come through exceptionally badly managed marriages which almost killed the bloated companies they created. The merger of Alcatel and Lucent in 2006, and the joint venture created between Nokia and Siemens in the same year (Siemens exited in 2013), have both become bywords for the wrong way to approach mergers, and they gave Ericsson and Huawei significant leeway to step into the breach and consolidate their shares. Both those deals were panic-driven, with traditional companies clinging together for warmth in an increasingly cold competitive climate, but without any clear vision of how they might evolve towards the realities of the future market. Sadly, nothing different could be said of a Nokia-ALU merger.

Amid the inevitable pain of the integration process, there is real risk that the new strategies both firms have put together will be lost. Logically, Nokia's mobile broadband should fit beautifully with ALU's approach. Under CEO Michel Combes, the French firm has, like its suitor, divested many units. It has drilled down on all-IP infrastructure plus SDN for growth, and on access (including mobile) for cash. On the wireless side, it generated €5bn in revenue last year and has a stronger US base than Nokia. These roadmaps seem complementary, but it is very doubtful that such new and therefore fragile strategies will be well combined by two still-traditional firms which are only just emerging from traumatic restructurings.

Nokia shares fell by almost 7% in Helsinki on its statements, but ALU's leapt by 14% in Paris, perhaps reflecting that investor confidence in the Finnish firm, especially since it addressed its cash shortage via the Microsoft deal, is higher than in ALU, and therefore the risk of a reversal of fortunes is higher.

One critical factor is how profitable a combined company could be in the short term. There would be medium term economies of scale, presumably including further large-scale cutbacks, but both have only tentatively returned to the black in the past year so the short term outlook is hard to predict. In 2014, Nokia's operating profit was €170m (its net profit was €1.2bn thanks to tax benefits), while ALU achieved an operating profit of €572m but a net loss of €83m. By contrast, Ericsson had an operating profit of SKr16.8bn (€1.8bn) and net income of SKr11.1bn.

As well as profit considerations, there will be significant regulatory review which could include intervention by the French government, which is very reluctant to see national businesses sold off. The balance of power between the French and US elements of Alcatel and Lucent was a complicating factor back in 2006 (the insistence that CEO Pat Russo should be based in Paris was blamed for weakening ties to key customers like Verizon, for instance). France may have moved on from former president Chirac's comments that Finland has the worst food in the world, but the administration of Francois Hollande will certainly scrutinize any bid for ALU carefully and has a track record of trying to block corporate mergers. Alcatel traces its roots back to 1898 and has been a flagship French firm, though it was privatized in the 1980s.