Fumata Bianca: Avaya Finally Named Nortel Enterprise Auction Winner

Whenever a new Pope has to be elected, after the papal election process is complete, the Vatican announces the results to the world according to tradition. The ballots are counted and bound together, then burned in a special temporary oven in the Sistine Chapel and the smoke exits via a chimney that is visible from Saint Peter’s Square. Typically when the vote is successful, the ballots are burned alone, sending white smoke (“fumata bianca”), which tells the faithful gathered that a new Pope has been chosen. However, if the vote does not produce a clear consensus winner, a compound is added in order to produce black smoke (“fumata nera”). 

 

For the many reporters, industry and financial analysts and Nortel employees that were anxiously expecting a final verdict on the stalking horse auction of Nortel Enterprise assets from the U.S. Bankruptcy Court (in Wilmington, Delaware), September 11, 2009 was a fumata nera day, with no decision being announced and perhaps even less of an indication of the auction’s status. After a day of waiting, many folks anxiously expected more news on Saturday, then Sunday, but nothing new emerged other than a few unsubstantiated rumors and information that the final result would be known today. The fumata nera day had become a fumata nera weekend. But, the white smoke finally came in today (Monday), with Avaya being declared the winner of the Nortel Enterprise auction.

 

Verizon Communications, an important channel for both Nortel and Avaya, raised an objection on September 10 to Avaya’s (News - Alert) initial $475 million bid, citing “public safety and security concerns.” Verizon wanted to get assurances from Avaya that if it were to acquire Nortel’s enterprise business, Verizon’s existing contracts with Nortel would be taken up and serviced by Avaya. This is particularly important for U.S. Government contracts, as they rely on these maintenance, service and support arrangements to keep their communications flowing smoothly. When a service provider selling bundled services on top of enterprise telephony infrastructure from a vendor offers such contracts to customers such as the U.S. Government, the typical modus operandi is for both to co-sign the service guarantees.

 

This situation gave rise to a lot of speculation by many industry pundits, which is what typically happens when information is scarce and they are asked to provide feedback on the auction. But what can be reasonably safely conjectured is that if some of these maintenance agreements were renegotiated more recently, chances are that Nortel might have offered more advantageous terms to Verizon as an incentive for the service provider to maintain the Canadian vendor in its equipment supplier list. During times of hardship, particularly considering the current economic downturn and the uncertainty overhanging the company ever since its Chapter 11 filing in January, such measures would not be surprising. In fact, in June, Nortel introduced a comprehensive lifetime warranty for its stackable ERS (Ethernet Routing Switch) portfolios, an unprecedented step in the industry. 

 

Another issue that begs an explanation from Avaya (which was difficult, considering the bidding process was still ongoing when the Verizon announcement went out) is why would the New Jersey-based vendor risk upsetting such an important channel as Verizon? Some observers speculated that Avaya’s lack of commitment signals that it might be trying to renegotiate more favorable terms for the support deals. But that could prove to be a high risk, high reward type strategy because, even if Verizon budges on this front, it can, at the same time, start pushing more Cisco gear (Cisco is another enterprise telephony supplier for Verizon), thereby hurting future Avaya sales. Another more plausible possibility is that some agreements included not only product support but also guarantees and continuation of development of some product. If this is the case, Avaya would be on a very difficult position to be able to offer such guarantees in advance of a possible victory in the Nortel Enterprise sweepstakes. 

 

Obviously, Verizon does not want to be the only player left holding the service and maintenance contracts hence their objection was made. But ultimately, it is in both companies’ interest to resolve their impasse, as Avaya risks upsetting an important channel. On the other hand, Verizon is also exposed to the risk that the courts might not validate their position (even after appeals), thereby leaving the service provider in a tough spot. That is why this is probably an obstacle that will be eventually overcome. 

 

Avaya was declared the winner of the auction with a $915 million bid after the three-day bidding contest. The New Jersey-based company claims that the price includes a $15 million employee retention plan (Nortel Enterprise has a workforce of about 7,800 employees globally and 1,050 in Canada). It does give Avaya the leadership in the North American enterprise telephony market, catapulting the vendor over Cisco. As a bonus, it also prevents Siemens (News - Alert) Enterprise Communications from gaining strength in North America and becoming a more difficult foe to fight on Avaya’s home turf. Siemens was the company that had the most to win, but also the most to lose with this auction (despite being a leader in countries such as Brazil and regions such as Europe, North America has historically been the Achilles’ Heel for Siemens).

 

But, this win will certainly create many challenges for Avaya, including ensuring a smooth M&A integration, which is difficult considering the large product overlap between the two companies. Rationalizing similar product portfolios is a difficult task, as there are many criteria that need to be taken into account including product features and functions, competitiveness (including pricing), installed base and others. Furthermore, long-term product roadmaps need to be devised so that customers could be migrated in a seamless fashion.

 

Another challenge is taking care of the existing Nortel customer base, and guaranteeing that they will be updated regularly on product development, maintenance and support news. More importantly, this installed base also needs to be kept abreast of any EoL (End of Life) decisions well in advance, and be given flexible options to smoothly transition from one product family to another. If this does not happen, some of these customers can trigger an RFP, whose final outcome might not be favorable to Avaya. The preservation of the installed base will certainly be one of the key yardsticks that will measure the ultimate success of this transaction.  

 

Finally, there is the human element. The consensus among M&A experts is that roughly one of every five mergers works out well, but from the other four that don’t, 90 percent of them fail due to cultural differences. It will be very important for Avaya to instill its culture and to alleviate any tensions arising from philosophical differences right from the beginning of the integration exercise.

 

As Orson Welles once said, “If you want a happy ending, that depends, of course, on where you stop your story.” While Avaya has just been declared the winner of the Nortel Enterprise sweepstakes, much needs to be addressed before the deal gets ratified and the integration exercise begins.

 

On the path to regulatory approval, a big concern has to do with the changes in the competitive landscape as a result of the auction and whether an Avaya victory would result in a Cisco/Avaya market duopoly in North America. This is a big issue, as the Department of Justice (DoJ) will take a close look at the transaction to ensure that there is still enough competition left in the marketplace after the auction is complete. The key question to be asked is what unit of measure will the DoJ apply? If it looks at total number of lines including SMB and larger enterprise systems, an Avaya/Nortel merger would pass the Herfindahl index calculation (the resulting index would be under 1,400, which is below the 1,800 threshold for a “concentrated” market). However, the result would greatly change if the DoJ were to consider different market segments by size of installation. For instance, for large enterprise systems (400+ lines) in the US, the combined Nortel/Avaya share would far exceed the 1,800 mark. 

 

Another difficulty might arise if the DoJ considers different product categories. For instance, a Nortel/Avaya fusion would yield a combined market share of at least 45 percent in the contact center space, which again would put that above the Herfindahl 1,800 threshold. In such an instance, the DoJ might grant the bid to Avaya (if it applies the total measure and includes both enterprise and SMB systems) but might force it to dispose the Nortel contact center piece (installed base of Symposium customers plus all the server/software products and IPR). 

 

The rubber stamp from the DoJ is sine-qua-non, as the Avaya offer has an anti-trust “out” clause that enables Avaya to walk away from the deal should regulators force the vendor to sell Nortel ES assets to avoid having too much market power. Even with a “hell or high water” clause that obliges Avaya to do everything necessary to complete the transaction, the speed at which the wheels of Justice turn is the ultimate bottleneck and Nortel would have to keep its Enterprise business afloat (estimates of the OPEX necessary to achieve that are roughly $800 million per year, considering the current employee base of 7,800 people). Getting these regulatory approvals could take as long as seven months, and during that time, Nortel will be bound to the Avaya bid and, therefore, unable to search for other alternative suitors. This might not sit well with MatlinPatterson Global Advisers LLC which is one of the largest Nortel creditors, holding roughly $400 million worth of Nortel bonds.

 

Another curveball might be a repeat of the feverish Canadian flag waving that we saw at the end of the Nortel CDMA/LTE (News - Alert) stalking horse. Much of that agitprop was caused by RIM, which, to its credit, succeeded in triggering at least a hearing in Parliament Hill. Interestingly enough, at the height of the “Keep Nortel Canadian” pleas, an argument was made that the patriotic Swedes would never allow Ericsson (News - Alert) to fall in foreign hands (Ericsson was the winner of that auction). Nobody even mentioned the fact that Canadian-based Aastra bought Ericsson Enterprise AB in February 2008 without much fanfare in Sweden. 

 

But, branches in the Canadian Government had already been awakened and, not surprisingly, Sandra Pupatello (the Ontario Minister of Economic Development and Trade) stated that the Ontario Government was watching the Nortel ES auction “with great interest” and was ready to work with the winner to maintain as much of the unit’s operations in Ontario as feasible. Even though the Provincial Government itself might not quite be in a position to raise too many objections, there is the question of what the Federal Government might do, considering the Tories currently hold a minority government in Ottawa (but there are chances of another fall election and this can certainly become a political issue). While the Harper Government might take a more laissez faire attitude towards this topic, it is not clear what a Liberal (or a coalition) government would do. On the other hand, there could be some money coming in to Avaya in terms of credit facilities being made by organizations such as the EDC (Export Development Canada, the government-owned export credit agency). Obviously such credit facilities typically come in with some caveats attached to them, such as requiring Avaya to maintain a certain percentage of Canadian employees.

 

 

After John Paul I’s death lead to another conclave, the Vatican cardinals used army flares to clearly distinguish black from white smoke. But the black smoke turned gray leading to confusion. As a result, it was decided from that point on that the bells of St. Peter’s Basilica will ring in addition to the white smoke in order to make the election of the Pope clearer in the future. 

 

In the Nortel ES context, those bells will be rung by the US DoJ - once it gives Avaya the regulatory blessing from an anti-trust standpoint. The key question is what caveats (gray smoke) will come (if at all) and how will Avaya react to these caveats? And how long will it take for the DoJ to reach its verdict? These are hard to answer questions, but any discussion on future product roadmaps and the Nortel/ Avaya integration must be preceded by the outcome of the DoJ investigation and its ramifications.