Tekelec's Softswitch Strategy Places It in Battle With Giants

By RiSHAWN BIDDLE, Staff Reporter

In the topsy-turvy world of telecom, Tekelec Inc. has maintained a balance of growth and stability that's made it a popular stock.

Shares in the Calabasas-based firm have risen 77 percent over the last year, as it attempts to translate its dominance in a market for older switches into a new generation of switching products.

At a price of $19.79 on Jan. 19, shares are up 28 percent for the year. But the telecom equipment maker's new direction pits it head-to-head against bigger rivals such as Cisco Systems Inc. and Nortel Networks Corp.

Tekelec has a near-monopoly in the market for so-called SS7 switches, originally developed by Bell Laboratories in the 1980s. They route telephone calls from a busy circuit to an open one. SS7 switches are used to transfer an incoming call on a cellular network to voicemail, for instance, when the recipient is on the other line. They allow telcos to provide multi-circuit offerings such as 800 numbers.

The business, which accounts for 82 percent of sales, has been a sweet spot for Tekelec, providing gross margins of 70 percent. The company accounts for 75 percent of all the new switches bought by American telecom companies, according to Robert W. Baird analyst Ken Muth. Along with chief rival Alcatel SA, it controls 90 percent of the world market.

But a new generation of switches and the changing priorities of telecoms are forcing a change.

Within the past year, Tekelec customer Verizon Communications and other telecoms announced they're focusing on replacing aging equipment with new systems that can combine voice with data, thus eliminating the need for separate networks. They are replacing SS7 switches with softswitches, a form of the packet switching used to transmit e-mails. In softswitches, voice and data traffic are combined and compressed into digital signals.

While the rollouts will take another decade for telecoms to complete, Tekelec is already feeling the revenue hit. Switch sales fell 10 percent during the third quarter ended Sept. 30; overall revenues were $70.7 million, down from $73.5 million for the like period a year ago.

To avoid getting stuck in a no-growth market, Tekelec is offering its own softswitches. In June, it merged a division into Plano-based Santera Systems in exchange for a 52 percent stake and effective control. Last month, it snagged a small contract with Iowa Network Services, a consortium of telecom companies from the Hawkeye state.

Bigger foes

But while the market remains small, Tekelec doesn't have it to itself. Besides a coterie of startups, it's going up against far larger rivals such as Nortel, which has gotten a head start thanks to contracts with Sprint Group and Verizon. Another looming threat is router giant Cisco, which announced in December 2002 that it would dedicate $10 billion of its massive research and development budget to breaking into the market for softswitches and other telecom products.

Tekelec is looking to stay in the game because many telecom companies split large orders among two manufacturers. It's also betting that its control of the SS7 market will help it keep customers who would otherwise go elsewhere.

"Most of our rivals aren't steeped in both the established technology and the new generation as well. That is our advantage," said Chief Executive Fred Lax, a former Lucent vice president.

Tekelec was founded in 1979 as a distributor of telecom testing equipment made by a firm controlled by cofounder Jean-Claude Asscher, who also was the founder of IXIA. It then began manufacturing protocol testers, used to see if there are interferences on networks. By the late 1980s, it was selling those testers to telecom carriers that used them to diagnose their SS7-based networks. When the company found out that customers were using the testers as replacements for switches, it decided to move into that market.

During two money-losing years, Tekelec went through three different chief executives. But by 1997, it won a series of contracts with Sprint and BellSouth. It also managed to muscle out rival Lucent Technologies, whose Bell Labs division had invented SS7 while part of AT & T; Corp. Rather than stay in the market, Lucent agreed to resell Tekelec's switches as part of its other equipment offerings.

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