Telecommunications equipment company Nortel(NYSE: NT) plans to pony up $3.25 billion in stock to acquire Xros, a privately held start-up that makes optical switching equipment.
Under terms of the deal, Brampton, Ontario-based Nortel will issue about 27.5 million shares of stock on a fully diluted basis to pick up Sunnyvale, California-based Xros (pronounced ky-ros). Shares of Nortel bobbed up more than $4 in early trading as investors trust the market-share leader to make smart moves in the optical networking space. After all, more than 75% of Internet traffic in North America is carried on Nortel systems, according to a company release, and industry research supports this claim.
Why are optical products so hot? Fiber optic networks carry more information than copper wires, which were designed to carry voice traffic. As Internet usage exploded, customers started demanding more bandwidth. That's when phone companies and Internet service providers started laying thousands of miles of fiber.
Fiber networks come with their own set of challenges, however. For example, the signals have to be boosted for traveling long distances. It's a difficult, costly process that involves converting the pulses of light to electrical signals, boosting the signal, then reconverting it to light. The signals also must be reconverted when switched -- sent along on the right path. That's where Xros steps in. It makes products that switch light signals without converting them. It's a key piece of the puzzle for Nortel as it looks to provide end-to-end optical solutions for its customers.
The market for optical bandwidth management equipment is expected to jump from $543 million this year to $15 billion by 2004, and while it's hard to predict what the industry will look like in five years, consider that bandwidth demand is doubling every six to nine months.
Of course, $3.2 billion looks like a lot of money to pay for a startup company with 90 employees. Do the math and you'll realize Nortel is paying about $36 million per employee. Imagine that. Keep in mind, however, that Nortel is using its high-priced stock to pay for the transaction. Nortel's shares are up 320% over the last year as investors realized it's the company to beat in the optical networking space.
And at the rate bandwidth demand is doubling, companies like Nortel can't afford to develop needed technology on their own. Who's got the time? Better to acquire it, integrate new employees quickly, and gobble market share. It's a tough strategy to make work, but in less than a year Nortel has acquired eight companies without missing a beat. It knows how to integrate acquisitions and understands what technology it needs to build out fully optical networks.
Nevertheless, investors may still wonder why Nortel would pay $3.25 billion for a startup like Xros -- the same price it paid for Qtera in December. Maybe that's the wrong question. Rather, I'd like to know how it got Qtera, a startup with 170 employees, for such a song.
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