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.

What is going on with CableCARDs?

CableCARD, which most cable companies must start renting out on July 1 because of an FCC mandate, will let a variety of store-bought devices tune in premium cable channels. Simply by slipping the card into a slot on the back of any enabled equipment, such as a digital video recorder (DVR), a media-center PC, or a flat-panel TV, subscribers can get premium programming. It sounds too easy and interesting.

The problem is that cable companies, telephone outfits, and consumer-electronics makers are back at it, fighting over your TV set. The little credit-card-like device could determine how much money these companies collect when viewers in the near future can start downloading most of their premium movies and videos from the Internet. All these companies are throwing in all kind of extras to get you to use their gear, or not use the opposition's. For instance, TiVo Inc. is offering the Amazon.com Unbox movie-download service. Comcast, Time Warner and other cable providers are likely to do everything possible to keep you from buying a competing device at a store. New cable customers have to call them to get a CableCARD, no matter where they plan to use it. And, of course, cable providers are working hard to point to the downside of using separately purchased equipment. Some cable providers may charge as much for a card as you now pay to rent a box.

What is more intriguing is that equipment different from Set-Top-Boxes (STB) provided by cable companies such as DVRs and TiVo’s, doesn’t allow cable customers to watch on-demand shows. In fact, cable companies will license software to let such equipment makers offer on-demand and pay-per-view, but only if they agree to display prominently the cable provider's logos, ads, and programming. That's a deal-breaker for many companies that are trying to establish their brand and make money off downloadable content.

Makers of DVRs and other gear see CableCARD as the future. It would provide vastly more choices as companies strike deals to allow movies and other content to be pulled directly from the Internet. If that happens, it would be the end of cable. Honestly, I don’t see happening any time soon.

Cox Communications loves Customer Care

Today’s discussion is something that I’ve been thinking for a while but never really found a company that sets the example. But lucky for us, the consumers, that might be changing. U.S Consumers generate about $60 billion of yearly revenue just on voice plans. In fact, cable companies have been laying miles of new fiber-optic cable and doing everything they can to steal chunks of that business from the phone giants. However, they haven’t been very successful yet, pulling away just about $5Billion in phone revenues.

There seems to be one exception, Cox Communications. They found a formula that works, which is beating phone companies on customer service. On a variety of metrics, from network performance and reliability to billing and cost, customers in several regions describe Cox as their preferred provider. That is a big surprise given the poor reputation that many cable providers have among their own customers. But developing crossover appeal will become increasingly important as the broadband lines blur. Cable companies are offering new phone plans; AT&T and Verizon are launching TV and other advanced video services. Further, Cox, Comcast, Time Warner, and Advanced Newhouse Communications are beginning to sell a wireless phone service, Pivot, in select markets.

Let’s keep in mind that phone is the fastest-growing portion of most cable company’s business. For instance, Cox is generating about $1 billion a year from its 2.1 million phone customers, with profit margins of about 50%-60%, with nearly 20% of the homes in neighborhoods where it offers phone service signed up, according to researcher IDC. Conversely, less than 7% of customers in cable giant Comcast's neighborhoods take its phone service. (Cablevision Systems Corp. has the industry's best phone-penetration rate, 29%). On the other hand, phone companies capture 5% or less of their potential TV customers.

But let’s get back to customer service. First, Cox uses one customer-care provider, with U.S.-based centers. Second, rather than pushing agents to hurry customers off the phone and causing multiple call-backs, Cox strives to handle issues in a single call and grades representatives on how well they eliminate problems. Third, to avoid confusion, field technicians tap into the same system used by call-center reps. However, performing at the same high level in wireless could be challenging as they will use Sprint Nextel Corp.'s cellular network, which has been overwhelmed with problems after Sprint's troubled integration with Nextel. Also, cell-phone service is one area where consumers seem less eager to switch. So, it will be Cox’s job to convince customers that cable companies can provide wireless service and customer service at the same time.

And it finally happened: Alltel goes private

On a much expected deal, TPG Capital LLP and the private-equity arm of Goldman Sachs Group Inc., agreed to purchase wireless operator Alltel Corp. for $27.5Billion, in the largest venture of private-equity money into the wireless business. The buyers will pay $71.50 per share for the company, which represents a price of about 10% higher than where the shares traded last Friday. The buyout group will put $4Billion of its own equity, while banks led by Citigroup Inc. will make “equity bridge” loans of greater than $600Million.

Now, let’s see the strategy behind this deal. Alltel has 12 million subscribers mostly in the Midwest, West and South. The company became an attractive target after spinning off its wireline unit last year to put more focus on the faster-growing wireless telecom business. From the finance standpoint, Alltel shares trade around 9 times its cash flow, an attractive multiple to private equity buyers who are increasingly paying in the double-digits as competition for deals grows tougher. So far, so good.

There are two key points that trouble me a bit. How about the strategic questions that new buyers will face? First, it is unclear how the company will approach the bidding in a coming Federal Communications Commission auction of radio spectrum for wireless broadband communications. This new spectrum and the building out of a new high-speed wireless network would be very costly; however, it might be necessary as larger competitors, such as AT&T, Verizon Wireless and Sprint Nextel are all increasing the speed available on their networks to offer new applications. Up to now, management said the company is willing to invest in its network. However, it seems to be very difficult to predict which direction the company will take, but this is a key fact or to consider moving forward.

I think the Alltel deal is just the beginning of a huge wave of telecom deals. Private-equity investors are showing strong interest in telecom companies. Just to mention a few deals, in Canada, Kohlberg Kravis Roberts & Co. and three pension funds have been in discussions to buy BCE Inc. In the U.S., Sprint-Nextel has also been a rumored target during the last month. So, let’s expect more deals and action to come in the always exciting telecom sector.