Vendors face tough spending choices

Renowned investor Carl Icahn's quest to attain a seat on Motorola's board and return some of the company's $7 billion in net cash to investors is highlighting investor scrutiny of balance sheets in this space. But vendors across the sector are facing tough choices about how they spend — or don't spend — their resources. In a consolidating climate, they want plenty of cash on hand for possible acquisitions and plenty of funds devoted to R&D to stay competitive. Finding the right balance, so to speak, is the challenge.

“Microsoft, Cisco — people with a lot of cash are looking at their balance sheets in a new light,” said Krish Prabhu, Tellabs CEO, at an investor conference this month. His board of directors recently appointed a special committee to evaluate the company's use of cash, enlisting the aid of outside advisers.

Like many tech firms, Tellabs has never paid cash dividends. Instead, it has bought back billions of dollars of its own stock in recent years, giving existing shareholders a bigger stake in the company. Tellabs bought more than 22 million shares of its own stock last year at between $9 and $13 per share and last summer authorized a new program to purchase up to $300 million of its own stock. Having made its fair share of acquisitions over the years, Tellabs today is described more often as a hot property than a likely buyer. “There aren't too many good target companies out there,” Prabhu said.

“One of the problems in high-tech industries is that successful companies tend to generate cash pretty liberally, [but] they don't have good places to put it,“ Eric Schmidt, Google CEO, said at an investor conference this month. Of Google's more than $11 billion, he said, “It is not obvious to me where it would go.“

Sycamore Networks is well-known for hoarding nearly $1 billion in cash while it weighed its options. After finally acquiring edge router vendor Eastern Research last year, that business' revenue is down from its 2005 levels. Still, Sycamore is generating cash, and with $915 million — which the company calls “a key strategic asset” — it's keeping mum on future acquisition plans.

After making a string of acquisitions between 2002 and 2004, Ciena has put the brakes on mergers and acquisitions, holding onto $1.2 billion in cash, equivalents and investments, and making the normalization of its business its top priority. The vendor raised investors' hackles recently by increasing operating expenses in order to pump up sales and R&D for a particular unnamed target that could yield returns in 2008 and 2009.

“What's on the other side of this operating spending rainbow?” one analyst asked during the company's earnings call this month. “It's incumbent upon you to share with us why you're doing it.”

In general, Ciena has been forced to grow R&D to meet the demands of its top-tier clients. In the most recent quarter, Ciena spent more than 17% of its revenue on R&D. Though it will increase its R&D spending in coming quarters (less than 5% sequentially per quarter, analysts believe), it insists its operating expenses as a percentage of revenue will go down this year. “[Ciena] will constantly need to invest in R&D and sales and marketing to improve its competitive position and develop new products,” wrote Tal Liani, Merrill Lynch analyst, in a recent note. Last summer, Liani called the sector “extremely under-leveraged,” criticizing Motorola in particular but citing Ciena as an exception.

“What is the right balance sheet?” Prabhu asked. “We're taking a good hard look at it.”