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I remember the days when Venture Capitalists (VCs) used to stalk telecoms conferences looking for software companies with potential. investing in telecoms applications was no guarantee of success but they knew that the potential market for the products had a reputation to spend up big for the ‘right stuff’.

CSPs generally don’t run big, creative IT departments any more, either, so the industry relies on independent software vendors (ISVs) to produce the goods.  According to analyst firm, Ovum, telecoms vendors continue to spend in the range of 13–14 per cent of their revenues (on average) on Research & Development (R&D). However, as I suspected, venture capital funding of telecoms vendor start-ups has fallen steadily in the last few years.

Even with this drop, telecoms-related patent filings are still on the rise, but there’s a growing consensus that telecoms vendors’ differentiation must come from software, applications, and services. Principal Analyst at Ovum, Matt Walker, also worries that current trends in venture capital and vendor R&D threaten innovation.

Annualized R&D expenses as a share of revenues have fluctuated in that range of 13–14 per cent on average, over the last three years for a group of ten large telecoms systems vendors that Ovum studied for this research. Chinese vendors (Huawei and ZTE) are below average at around 9-10 per cent, while Juniper, Nokia Siemens Networks (NSN), and Ericsson are well above average.

“Because of recent market consolidation and cost pressures brought on by hard-bargaining carriers and aggressive Chinese vendors, many big western vendors are cutting back staff and closing facilities”, adds Walker, based in Thailand. “This may lead to lower R&D/revenues ratios in the future. More important is the trend we have already observed in venture capital, which typically funds the “game-changing” ideas that big vendors often ignore”.

VC support for telecoms vendors has fallen steadily in the last few years, from $1.82 billion for the four quarters ended 3Q08 to just $1.18 billion in the 2Q09–1Q10 period. As a percent of the ten big vendors’ internal R&D expense, vendor VC funding has thus fallen from 5.6 per cent in 3Q08 to just over 4.0 per cent in 1Q10. Ovum believes this poses a substantial risk to carriers in the level of innovation they will be able to internalize by working with, acquiring, or even copying successful start-ups.

The costs of lower levels of internal R&D and VC-driven investment come in several areas:
•   slower introduction of new technologies
•   more reliance on the standards process before product introductions (and an aversion to introduce anything proprietary, even when it is “better”)
•   potentially less differentiation in product areas that feature innovative approaches
•   less potential for M&As, given fewer attractive targets.

Chinese vendors have a strong incentive to exploit others’ weaknesses right now. Walker also believes that they are eager to earn their stripes as innovators and may be able to do so faster while western VCs and vendors are distracted, and I couldn’t agree more. They may consider creating venture funds of their own, along the lines of what many large tech players have done, e.g. Intel, Microsoft, Motorola, and Google. Short of this, they can also open new R&D facilities in locations hit by the cutbacks (and bankruptcies) of their western competitors. Huawei, in fact, announced in April 2010 that it would build a new R&D center in Kanata, near Ottawa, Canada, presumably trying to tap some of the skilled engineers who formerly worked for (or around) Nortel and are now scrambling for work.

Whatever may evolve, there is no doubting that lack of investment in new software and applications will impact the industry dramatically as it tries to ward off non-telco competitors who are investing in R&D.

* The report, available from Ovum, is entitled “Is Telecom Innovation at risk?”