Avaya: The Next M&A Target

The telecommunications company Avaya Inc. is in negotiations to sell a part or all of itself, in what may be the latest round of deal making in its industry. Among those interested are two rivals — Cisco Systems and Nortel Networks — and the equity buyout firm Silver Lake Partners. Avaya, based in Basking Ridge, N.J. and valued at $6.1 billion, has retained the investment bank Credit Suisse as an adviser. The company, the one-time business communications arm of Lucent Technologies, and before that AT&T, is one of the nation’s top makers of phone equipment, rivaling Cisco, Nortel and Alcatel-Lucent in providing Internet-based communications to corporations.

Of course, this is not a surprise. The telecommunications sector has proved mature for deals recently. Actually, there should be more consolidation in the telecom-equipment industry. The massive consolidation among telecom carriers in the last few years have left telecom-equipment space too crowded, with too many vendors chasing after too few deals. Smaller equipment makers such as Avaya have to do their own deals to compete with their bigger rivals. Last year, telecom equipment manufacturers Alcatel and Lucent merged in an $11.6 billion transaction. In addition, Western equipment makers are facing pressure from low-cost Asian manufacturers, as well as the growing size and purchasing power of a few large phone companies.

Why Avaya is an ideal target for private-equity firms? The company has $829Million in cash and no debt; it generates strong and stable cash flows combined with increasing profit margins. The company provides equipment that moves traditional phone systems onto integrated IP network platforms that provide voice, email, conference, IM and video communications. About half Avaya's revenue is derived from long-term service contracts, which ensures even more recurring cash flows.

So, why Nortel? First, a Nortel-Avaya deal would be consistent with Nortel’s strategy of increasing focus on enterprise and professional services. In a research report, UBS analyst Nikos Theosopoulos said buying Avaya would give Nortel 30% of the enterprise voice market, as well as more scale in the services business. However, I’m not sure Nortel is ready for such a big move. Despite the progress made by CEO Mike Zafirovski in restructuring the company, there is still plenty of more work to be done and operating costs to be reduced. An acquisition would definitely complicate the situation. On the other hand, Nortel has no choice but to move forward with the deal in order to compete with bigger equipment maker providers, such as Cisco Systems, Inc.

The way I see this potential deal is quite simple. Another big wave of consolidation is around the corner in the telecommunications industry. It doesn’t really matter if buyers will be private-equity firms or competitors. It is just the inevitable path for an industry that is becoming more mature.