A Bigger, Stronger Kenan

Posted: 03/15/1999

A Bigger, Stronger Kenan
Lucent's Acquisition Lends Heft to Thriving OSS Sector
By Doug Ashton

Every industry has big events or what are categorized as defining moments. In telecommunications, they come so fast and so often that, over time, they fail to illicit the kind of enthusiasm they deserve, often to the astonishment of the parties involved. In the operations support systems (OSS) space and the subsegment called billing and customer care, however, the opposite has happened. Many have long wondered when some of the leading billing and customer care vendors would get acquisitive, buying products for applications or markets they do not address, purchasing solutions sets they do not have (license fee vs. service bureau), buying technology on the rise (UNIX or Windows NT) or buying products that sit outside of billing (i.e., provisioning or network service or order management systems). Oddly enough, the industry's key transaction was instigated not from within but from the largest infrastructure provider in the world.

In what is the industry's largest transaction to date (which excludes spin-offs and initial public offerings [IPOs]), Lucent Technologies Inc., Murray Hill, N.J., acquired Cambridge, Mass-based Kenan Systems Corp. for approximately $1.48 billion in stock. The deal is expected to close by the end of March and will be done using the pooling-of-interest method of accounting. And, like many deals, even longstanding rumors of its happening still left many of us surprised. We understand employees of Kenan also were surprised. The fact that Kenan Sahin himself held all of Kenan's stock left other emotions in the mix as well.

At its most obvious level, every billing vendor that currently targets the same markets Kenan does will have to deal with a stronger Kenan. As Kenan spreads its wings under Lucent, this potentially could impact others vendors down the road, but for now, the key segments impacted will be in competitive local exchange carrier (CLEC) billing and specialty high- and low-end wireline billing. With 40 percent of its revenues coming from international markets, the deal's effects are not limited to the U.S. market.

We believe this is the first nail in the coffin of best-of-breed. With so much customization and services work to be done in billing and non billing OSS implementations, we believe many carriers are looking less for the best software for each applications set and more for a single vendor that can handle as much of the back-office product and services installation as possible.

While the Lucent/Kenan combination currently does not have the capability to supply the whole suite of back-office systems, they are moving down a slippery slope that will pull other vendors in the same direction. We believe this means that billers will begin to take a more formal approach to adding nonbilling OSS technology and leading OSS vendors will take a similar tack toward billing. Some are likely to meet in the middle.

If Lucent begins working its OSS product line into large infrastructure deals, this will expose an important hole in other large vendors' product lines and may spur action. Some vendors such as Nokia and Ericsson have loose arrangements with smaller vendors; whether this turns into a more formalized process may await Lucent's presentation to the market of how it will bundle software and services. What also will be important to watch is how willing Lucent will be to finance billing and customer care and OSS systems purchases, which could affect pricing.

Not suprisingly, most vendors are seeking to place the most favorable spin they can on the transactions. Commentary from them has generally centered on three fronts: "This deal will help us get additional integrators as Kenan's integrators will look to partner with other vendors;" "Kenan will now have difficulty selling to carriers that have non-Lucent networks;" and "This deal validates the sector." While the first two have some basis in fact, the last is a bit of a reach. Clearly, a sector such as billing and OSS--which is inhabited by vendors with multibillion-dollar market capitalizations, is a multibillion-dollar industry, has its own magazine and trade shows and the technology of which is in place at almost every carrier around the world--needs little validation.

What these comments seem to be saying is that this transaction will create some opportunities and that it's not all negative. We think this is true, whether it be at the relationship end or just picking off valuable Kenan employees. The Boston Globe, the local paper in Kenan's region, has been filled with "help wanted" ads from a number of vendors already.

While some gasped at the valuation, roughly 8.5 times 1998 sales, the price served two purposes--one good and one bad. First, this deal may have set a ceiling on valuation in the group. Kenan's stated top-line growth rate (doubling in size for the past three years), pretax margins in the 20 percent to 25 percent range and high weighting to license fees in the license/service split means that it potentially had the best financial model in its space. While we think the price was too low, it may not be easy for other vendors to show why they are worth more.

On a more positive note, the high relative valuation to other sectors is likely to raise the bar on lesser vendors and for private market transactions. This is true because other vendors will be looking to fill holes in product lines raising the rates on the relatively few real companies that could fit the bill. The price also provides cover on acquisition pricing, as anything in the space bought at three to five times sales may look like a good deal.

With all the separate issues that this transaction presents to the OSS and billing and customer care industries, it is no wonder that many in the space view this as such an important transaction. As in other industry segments that have lived through such events, what ends up being more fun to watch is the activity that comes in its wake.

Doug Ashton is senior vice president of equity research at Jefferies & Co., Los Angeles. He can be reached at dashton@jefco.com.