Scope Of Flextronics Deal Fuels Concern Over Nortel

Flextronics Corp.'s massive deal to assume most of Nortel Networks Inc.'s equipment manufacturing doesn't end there: In a move that has raised eyebrows, Flextronics is also taking over most optical-product design from the financially troubled Canadian company.

Analysts last week suggested the latter move may have gone too far, noting that outsourcing of systems design activity could turn Nortel into a system-integration and software company by default.

"Nortel needs cash and seems to be making decisions on manufacturing and design without saying to itself and investors, 'What is the long-term strategy?' " said Ron Westfall, infrastructure analyst at Current Analysis Inc. "Perhaps a move to outsource so many steps in design could be managed successfully, but Nortel has not articulated that vision."

Analyst Frank Dzubeck, president of Communications Network Architects, conceded that "design assistance among vendors is common: Cisco, for example, paid a small fortune to IBM for their latest router project, particularly for help in ASIC design. But outsourcing a whole design division? I've never seen a company of this size abrogate intellectual-property responsibility."

Philippe Morin, general manager of the optical-networks business at Nortel (Brampton, Ontario), admitted the company took a radical step but said the move is a "re-creation of the vertical model of integrated design and manufacturing we had 10 years ago." Manufacturing of some steps had been outsourced piecemeal, separating design teams from manufacturing groups, he said. The Flextronics design work will be limited to "well-established platforms," while advanced optical-system design will remain within Nortel for photonic, physical-layer electronic, higher-layer protocol and software design steps.Flextronics (Singapore) will pay Nortel between $675 million and $725 million under the deal to take over manufacturing lines with a combined annual revenue of $2.5 billion. The lines include all of Nortel's wireless and optical manufacturing, as well as a majority of enterprise manufacturing, with the exception of some businesses that were part of Bay Networks. Nortel will retain manufacturing of its wireline network products.

Flextronics will take over Nortel manufacturing plants in Canada and Brazil and will transfer 2,500 Nortel employees to Flextronics. The EMS provider will handle systems integration, final assembly, test and repair, and supply chain management. Additional manufacturing operations in France and Northern Ireland may transfer to Flextronics. For optical-systems design, the Singapore manufacturer will handle hardware development, software development and project management.

Except for its remaining wireline manufacturing in Ottawa, "Nortel will have virtually no manufacturing left after this transaction," Flextronics chief executive officer Michael Marks said in a conference call with analysts. Marks said that Flextronics won't shift manufacturing from the Nortel plants to its own Asian facilities in the short term, but he added that "we have the right to put these products where we want to put them."

When asked if critical design teams might be moved to Asia, Nortel's Morin said that "Flextronics was willing to pay a premium of close to $200 million for design resources alone. The skill set of optical-design groups in Ottawa is very good, and I think Flextronics wants to be considered a leader in design expertise among contract manufacturers, so they will not want to move or replace that Ottawa resource anytime soon."

But analyst Dzubeck said the phasing out of Canadian Nortel plants might happen sooner rather than later, because Nortel's printed-circuit-board plants in Montreal and in Calgary, Alberta, are outdated and inefficient, partly because of provincial-government mandates on head counts. "Manufacturing itself is a natural to outsource because, in theory, board manufacturing is mundane, except at the very high end of 10-Gbit and 40-Gbit design," Dzubeck said. Less typical, he said, are the insights into design that Flextronics could gain by integrating photonic subsystems and electronics for Sonet, 1- and 10-Gbit Ethernet, and Fibre Channel.The deal also shows the growing sophistication of Flextronics in handling end-to-end design, development and supply chain operations for OEMs. Flextronics already serves as the primary manufacturer for Ericsson, Extreme Networks, Motorola and Siemens. But the Nortel pact represents a shift in network infrastructure.

"What is important and is staying with Nortel is its software and engineering design. That's where Nortel's intellectual property is, and it will keep it," said analyst Nick Lippis, the founder of Lippis Consulting Inc. "Nortel looks like it will be a software, design, sales and marketing firm when it emerges from its financial mess."

Meanwhile, Flextronics' most recent moves into embedded software could give that company a base of expertise in Internet Protocol soft switching and telephony signaling, aiming at the heart of Nortel's remaining wireline infrastructure business.

In early June, Flextronics picked up a 55 percent stake in Hughes Software Systems, the New Delhi-based voice-over-packet and SS7-signaling affiliate of DirecTV/Hughes Network Systems. HSS is developing software stacks for both cable TV and telephony service providers. Rumors were buzzing in Chennai, India, last week that Flextronics also wants to acquire FutureSoft, an Indian provider of communication protocol stacks to OEMs and ODMs.

Dzubeck expressed skepticism that Flextronics could become an instant expert in embedded communication software but added that with all telco-equipment chassis architectures turning to the Advanced Telecom Computing Architecture, software represents the last area left untouched by commoditization."If you abrogate as much core talent as Nortel has done, then there might not be a Nortel anymore, without an absolutely protected software value-add. You can't [even] say Nortel would become a services company, because they've already farmed out services," Dzubeck said. "As for Flextronics, a contract manufacturer won't automatically be the leader in embedded software, because the midlayer protocols like MPLS move directly into silicon, while the management-layer functions get executed on standard processors, and they shift from SNMP or Corba to XML.

"But think about what the mix of protocols in silicon, management in XML and design intellectual property in the hands of contract manufacturers could mean for this industry in the long term."

One thing the Flextronics deal should do, Dzubeck quipped, is silence the rumors, which surfaced at the recent Supercomm trade show, that Cisco Systems Inc. is interested in buying Nortel.

It's hard to say where the value in such an acquisition would reside, he said, since people, designs, supply chains and intellectual property all become outsourced in turn.