Tero's excellent article on vendor financing (now free on TheStreet.com):
thestreet.com
Will Vendor-Financing Woes Hobble Lucent's and Nortel's Wireless Units?
By Tero Kuittinen
Special to TheStreet.com
Nortel's (NT:NYSE - news) dilemma concerning third-generation mobile networks started drawing attention late last year, but back then, the issue still seemed relatively distant.
However, Nortel's profit warning and Lucent's (LU:NYSE - news) abruptly worsening financial situation mean that the issue of vendor financing of 3G networks is suddenly on the front burner.
The hugely expensive build-up of next generation W-CDMA systems starting to take place across Europe and Asia has led some vendors to inch out onto the thin edge of the vendor-financing ice-shelf.
For the W-CDMA wanna-bes, Nortel and Lucent, possessing a weak base of orders for a 2.5G network standard called GPRS (General Packet Radio Service) which is a stepping-stone to 3G for most operators means they have to offer extra incentives to get their foot in the door.
Neither Nortel nor Lucent anticipated the nearly universal adoption of GPRS by the operators of GSM- and TDMA-based systems, and, as a result, their market share in GPRS is low compared with their second-generation mobile network market share.
Lucent has been struggling with less than a 5% market share in both GPRS and W-CDMA -- when calculated using the subscriber base size of received orders. Nortel has been able to battle back from a share in the low single digits in GPRS orders, to the teens in W-CDMA orders -- but at the cost of ballooning vendor-financing packages that are now putting future order growth at risk.
Another complication has been the absence of a handset unit; Nortel and Lucent are the only mobile infrastructure vendors that can't offer packaged network/handset deals when they try to close third-generation orders. As a desperate last-ditch measure to establish a foothold, Lucent is suspected to have accepted a financing deal for Telefonica's (TEF:NYSE ADR - news) 3G network in Germany that busts all industry records -- possibly topping 200% financing for the network. This means paying for all the hardware and ponying up an equal amount for various services related to the launch of the service.
This has resulted in some eye-popping discrepancies -- Lucent's vendor-financing commitments were thought to top $8 billion at the end of last year; Nortel and Motorola (MOT:NYSE - news) probably stood around $3 billion and $4 billion, respectively, as estimated by Total Telecom. In contrast, Nokia (NOK:NYSE ADR - news) and Ericsson (ERICY:Nasdaq ADR - news) were estimated to have $1 billion exposures. These latter two numbers are probably somewhat higher in reality -- but nowhere near the scary peaks of Mt. Lucent.
The U.S.-Europe dichotomy isn't coincidental -- it reflects the trouble North American mobile vendors have had addressing the evolution of current digital networks along the path of GPRS and leading to W-CDMA. The instinctive reflex of Lucent, Nortel and Motorola has been to buy market share.
But considering the size of their payoff programs, the returns have been remarkably meager: Despite outspending lavishly, Lucent has been unable to crack even 5% of the 3G market. Its biggest claim to fame is a sizable German network order that will probably remain notorious in telecom history as the absolute peak of operator pandering.
As for Motorola, an early flood of news proclaiming its testing of GPRS network implementation has turned into a marked slowdown of new commercial GPRS deals. Motorola landed the early GPRS announcements on the back of its established GSM customer base, but that momentum has not been maintained.
As a result of all this, the combined total GPRS market share of Nortel, Lucent and Motorola is well below the individual shares of either Nokia or Ericsson.
Nortel's special problem is the extremely aggressive 3G timetables it has advertised. The company has used eye-poppingly early 3G network delivery dates to grab the "first-mover advantage" that is so sought after by North American telecom providers. But committing to unrealistic launch targets quickly turns from an advantage into a liability if contracts dictate stiff financial delay penalties.
Just when does the company start paying penalties if it is forced to admit that the launch schedules will slip? Buried in Nortel's profit warning was an ominous reference to how "European wireless sales for high-speed UMTS (Universal Mobile Telecommunications System -- The European implementation of the 3G wireless phone system) equipment are expected to be delayed from the fourth quarter to the first quarter." No kidding -- was it ever reasonable to claim anything else?
To understand how all this leaves Lucent and Nortel at a widening disadvantage, read Part 2.
Will Vendor Financing Woes Hobble Lucent's, Nortel's Wireless Units? (Cont'd)
This is the second part of Tero's article discussing the widening vendor financing problem in the wireless networking world. Be sure to read Part 1.
What next? If Lucent (LU:NYSE - news) has spent a bundle to lubricate operators and even that was not enough to give it meaningful 3G market share, what happens when the lavish spending stops? On its own merits, Lucent's W-CDMA division will be hard-pressed to land new customers. Obviously, Nortel (NT:NYSE - news) will face challenges as well, though its program has resulted in more than a 10% market share and can be argued to have given the company a necessary foothold to keep it alive. A lot depends on just what delivery dates were inked into Nortel's deals, the extent of the financing component and how draconian the slippage penalties are.
The Comeback of Competition
One important point here is that the early spending binges and current profit crunches have rendered Lucent, Nortel and Motorola (MOT:NYSE - news) unable to continue their strategies. They simply can't continue their initial payoff policies -- investor focus on vendor financing issues will now effectively bar them from offering lavish incentives.
The biggest fear about the 3G infrastructure market has been the gnawing suspicion that vendor financing may poison the well for all participants. Paradoxically, Lucent's and Nortel's shock news from Thursday may ultimately benefit the industry. Now that the torrent of vendor financing money will turn into a trickle, orders will be placed based on the real merits of rival bids.
Lucent's and Motorola's 3G market shares may seem low -- but they are probably artificially inflated even now. Nortel stands the best chance of continuing as a presence even without the vendor financing crutch; but it would not be surprising to see Lucent and Motorola withdraw from the market within two years. With their current order books, solid margins will be impossible to attain.
And here's the key to why companies have scrambled so frantically to land the first 3G clients; the second-generation mobile network orders are no longer enough to drive revenue growth from about 2003 onwards. The only way to maintain a successful mobile network division is to succeed in the third generation. Lucent and Motorola are now facing more than questions about their 3G strategy; it is the future of their entire mobile network units that will be tested during the next year or two. Nobody knows what the real competitiveness of these two companies is, but now that they have to stop buying market share, we are about to find out.
The Operators Will Be Next
Of course, the spillover effect on operators is the big unknown here. Many marginal entries to the 3G market have been launched just because equipment vendors have been only too happy to shoulder the risk. Now the calculation is going to change - and the outcome may be that we won't see the expected 4-6 rival operators in many 3G markets; and perhaps only three.
In the long term this is good for the industry, because it means that operators could actually make money, which would allow them to build 3G networks with a sufficiently dense pattern of base stations that can deliver decent performance. If that's true, then the overall infrastructure spending of three healthy 3G rivals can match the spending of five unprofitable operators. A smaller number of operators can ultimately result in greater infrastructure spending; it's the expansion orders that matter.
Just as importantly, healthier competition in 3G markets would enable companies that deserve success to achieve it. Siemens (SMAWY:OTC BB ADR - news) has been surprisingly robust in the 3G infra market -- could it actually hit 20% market share if it won't be forced into insane financing bidding wars in the future?
These long-term considerations will be furthest from the minds of investors obsessing about the next short-term sentiment swing. But in the long run, these are the critical issues affecting success. |
