R&D pipeline squeezed

Venture capital support for telecom vendors has fallen steadily in the last few years, from $1.82 billion for the four quarters ended 3Q08 to just $1.18 billion in the 2Q09-1Q10 period. Simultaneously, hard-bargaining carriers and aggressive Chinese vendors threaten to force the major vendors to spend less on R&D to compete. The result could be slower introduction of new technologies, less differentiation in product areas and reduced potential for M&A activity.

Major vendors have traditionally been averse to spend big on developing new technologies, content instead to let nimble start-up vendors without legacy "baggage" do the pioneering, risky research.

With fewer such start-ups being funded, though, vendors will have to rely more heavily on standards bodies and other industry groups for innovation.

In the face of budget crunches and fewer high-potential start-ups, big systems vendors have a number of options for better using their scarce resources, including more aggressively moving R&D to new locations, trying to lock in exclusive relationships with small, new suppliers, and discontinuing product lines with limited potential markets.

In this latter case, it may push its customers to migrate to higher-volume, more mainstream products or technologies.

Signs of growth

The VC market, however, is showing signs of life. The climate for public offerings has improved in the last two quarters, with 32 telecom IPOs while the previous four quarters saw a total of only 20. Markets are still turbulent, and some filings are yielding less money or taking longer to consummate than planned. But the spate of  IPOs suggests there is still room for small or specialist vendors to grow.

To support a business as a specialized vendor, though, companies will likely need at least $1 billion in annual revenue, an ability to forge partnerships with other vendors and to spend more of their cash on R&D than the major players.

Exit via M&A is also looking more realistic now the markets have cooled down. Cisco, telecom's M&A "king", splashed some cash in 4Q09, buying Tandberg and Starent.

According to Cisco's M&A overseer Chris Carmel: "The first half of 2009 was the nuclear winter... Volatility was so high, you needed to wait for it to settle. As we moved into the second half of the year, the world did start to settle and that was one of the driving factors to why Cisco really picked up its activity."

Nortel's breakup caused some reshuffling in 2008-09, giving some vendors (Ericsson, Ciena) new opportunities for expansion and others (NSN) new stumbling blocks. Now that these big M&A deals are settling down, the continued need for specialist telecom vendors will become clearer - and these almost always get their start with VC funding.

But these green shoots don't change the fact that the traditional pillars of the industry are going through tough times. And Chinese vendors have a strong incentive to exploit others' weaknesses. They are eager to earn their stripes as innovators and may be able to do so faster while western VCs and vendors are distracted.

They may consider creating venture funds of their own, similar to Intel, Microsoft, Motorola and Google. They can also open R&D facilities in locations hit by the cutbacks (and bankruptcies) of their western competitors. Huawei announced in April it would build an R&D center in Canada, presumably to tap some of the former Nortel engineers now scrambling for work.

At the same time, emerging markets like China are becoming the key growth drivers of the telecom sector. Such markets are often focused on doing things more cheaply. They are interested in new distribution models, cost sharing of areas like the mobile RAN, leveraging open standards when possible, and open versus closed or walled gardens.

Service providers in developing markets are interested in heft, scale, learning across markets, benefiting from users' creativity, and collaboration with vendors and systems integrators. They lean toward products that are small, inexpensive, robust, tested, proven and environmentally hardened. 

Matt Walker is a principal analyst in Ovum's network infrastructure practice