Nortel's: China Syndrome

Since the beginning of this decade, worries about Chinese cyber-spying have reverberated through the media, rocked the security industry and added billions to the U.S. government’s cybersecurity budget. Now, for Nortel Networks , those concerns may also have frozen a deal the struggling networking vendor badly needs.

Toronto-based Nortel, whose stock has lost 96% of its value last year, announced in September that it would sell its metro Ethernet business, an Internet-focused piece of the company that generates about $1.5 billion a year in revenue.

The most interested potential acquirer of that division of Nortel may be Huawei, which bid $400 million for Nortel’s offering in September, according to Avian Securities–a generous offer considering that the company’s current market capitalization, hammered by debt and missed earnings projections, languishes at less than half that value. More recent rumors suggest Israeli networking company Radware may be bidding as little as $50 million for the same division, according to the Israel news siteGlobes.

Huawei’s higher bid, however, came with a caveat: The Shenzhen, China-based networking giant has a murky history of cooperation with its homeland’s authoritarian regime. And concerns over Huawei’s government ties, according to some industry-watchers and security analysts, may have spooked Nortel’s customers that carry sensitive U.S. government data and scuttled the Chinese company’s offer.

Huawei, which didn’t respond to requests for comment, has good reason to want a chunk of Nortel’s business. It’s likely most interested in Nortel’s market share in fiberoptic equipment–8.5% of the world market according to Synergy Research, behind only Alcatel-Lucent and Huawei itself. Nortel’s 100-gigabyte-per-second fiberoptic switches are also significantly faster than the 40-GB-per-second switches that Huawei currently offers.

The Chinese company has long been searching for an opportunity to expand to North America. It tried a joint venture with Nortel in 2005. And though that deal was scrapped in 2006, it means the two companies may have closer ties than other potential bidders.

In an informal poll of 44 fiberoptics and Ethernet industry executives at the Carrier Ethernet World Congress last September, the telecom trade blog Light Reading found that 18 respondents named Huawei as the most likely buyer for Nortel’s metro Ethernet business, far more than other candidates like Cisco Systems or Ericsson . The second most popular response in the poll was “no one.”

But a deal between Huawei and Nortel would have raised security hackles: The company sells telecom equipment to major Internet carriers likeVerizon , AT&T , Sprint and Qwest, which in turn carry data for practically every government agency from the National Security Agency to the Pentagon. And given Huawei’s history, a tieup with the company would raise the specter of a hidden back door in a router or switch, siphoning that data to foreign spies.

A January 2007 report for the U.S. Air Force written by the RAND research group highlighted the military background of Huawei chief executive Ren Zhengfei: Before he founded Huawei in 1988, Ren was an engineering director for the Chinese military’s telecom research department. Today, “Huawei maintains deep ties with the Chinese military, which serves a multifaceted role as an important customer, as well as Huawei’s political patron and research and development partner,” according to the report.

A month later, the conservative think tank Heritage Foundation issued its own report, citing Huawei as a security threat and arguing that “if a PLA protégé firm acquired an American firm that provided computer network equipment, software and services to the U.S. government, the possibilities for cyber-espionage would be virtually unlimited.”

Those concerns may have derailed Huawei’s interest in Nortel. Eve Grilliches, a telecom analyst with IDC research, says she’s heard from sources close to Verizon and AT&T that as Huawei carried out its due diligence for the Nortel deal, it learned that the two U.S. broadband providers would likely stop buying Nortel equipment if the Canadian vendor was acquired by a Chinese firm.

“The deal made a lot of sense at first because [Huawei] really liked the technology,” Grilliches says. “But if Verizon and AT&T aren’t going to use the equipment, what’s the point?”

The telecoms wouldn’t be the first to get skittish about Huawei’s involvement. Shortly after the Heritage Foundation and RAND published their reports last year, the White House’s Committee on Foreign Investment in the United States blocked Huawei’s attempt to purchase Ethernet company 3Com as part of a joint venture with Boston-based Bain Capital. Regulators were concerned that the Chinese military would gain access to 3Com’s cybersecurity unit, known as Tipping Point, which sells software to the U.S. military.

Marcus Sachs, Verizon’s executive director for national security policy, declined to comment on whether the carrier would be wary of buying Chinese-owned hardware. But he argued that the situation wouldn’t be unique: The increasing globalization of information technology means U.S. companies are using foreign-made equipment more than ever before.

“The U.S. now has to understand the fact that we no longer corner the market on high tech devices and software,” he says. “We all have to recognize that hardware and software are going to come from China. We have to make risk-based decisions, including these emerging threats where a foreign country might directly insert malicious code or hardware.”

Such direct spying isn’t simple, argues Marcus Ranum, chief security officer of Tenable Security and author of The Myth of Homeland Security. Hiding undetectable vulnerabilities or data-thieving code in networking hardware is tricky work.

“As a security guy, you look at your entire risk profile and ask what is going to go wrong,” he says. “The chance that a Chinese company would build trap doors into our core infrastructure is a silly thing to worry about when federal government is outsourcing much of its operations already.”

Far fetched or not, Ranum says, the technical difficulties involved with using Nortel equipment for cyber-espionage wouldn’t quiet worries if the Chinese vendor were to buy Nortel’s metro Ethernet division. Ranum says the deal would still seem suspicious in the eyes of government officials “with more imagination than technical knowledge.”

Other suitors for the Nortel unit may still be on the horizon. Aside from Radware’s offer, Ericsson, Cisco and Nokia Siemens were all named as potential buyers in a note to investors from Avian Securities partner Avi Cohen in late December.

But there’s also a chance no company will buy Nortel’s metro Ethernet division, says Synergy Research analyst Ray Mota. Rather than bid on the business unit, Nortel’s competitors could simply wait for the company to slide into bankruptcy. At that point, other telecoms could snap up assets as cheaper prices–or simply woo Nortel’s customers.

Since Nortel’s drill-bit stock price could get it booted off the NYSE, losing a bid from Huawei signals bad news for the beleaguered company, says Mota.

“Without it,” he jokes, “they may need a bailout from the Canadian government.”