Report dated october 6th right on!!
Health of carrier industry makes sharp deceleration in spending
likely
Paul Sagawa
Matthew Nagle
Reversing recent trend, telecom equipment sales to fall to less than 20%;
LU, MOT, COMS, NOK, PALM preferred; NT, CSCO downgraded
Copyright 2000, Sanford C. Bernstein & Co., Inc. ~ 767 Fifth Avenue ~ New York, New York 10153 ~ (212) 486-5800. All rights reserved.
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Our rating codes are:
O = Outperform
M = Market-Perform
U = Underperform
3
BERNSTEIN RESEARCH SEPTEMBER 29, 2000
Telecom Equipment: 2001 Carrier
Equipment Spending to Decelerate
Overview
Our analysis of 59 North American and European tele-communications
carriers leads us to conclude that capi-tal
spending on telecom equipment is likely to show a
sharp deceleration from more than 28% growth in 2000
to less than 20% growth in 2001. Carriers report total
U.S. and European CAPEX (dollar denominated),
which includes nonequipment spending, is projected to
decline 3% in 2001, after rising 31% in 2000. While
carriers have historically underestimated their eventual
capital spending requirements, and equipment is in-creasing
as a percentage of total capital spending, we do
not believe these factors are sufficient to explain away
the threat represented by carrier plans to reduce total
spending in 2001.
Carrier surveys completed one year ago reported
expected U.S. spending growth of about 8%, considera-bly
short of the projected 36% 2000 growth. Given sur-vey
results projecting a 9% decline in U.S. spending, it
is a stretch to assume that the spending growth rate will
not show considerable deceleration. We believe the car-rier
industry environment, marked by deteriorating fi-nancial
performance, bankruptcies, falling share prices,
rumored consolidation and increasing costs of capital, is
not conducive to the aggressive upward spending revi-sions
observed in the past three years.
We believe worldwide equipment sales will be up
more than 28% for 2000, below the 31% total carrier
CAPEX growth due to an unusual increase in non-equipment
spending (e.g., laying fiber). Based on a re-versal
of that trend, we project equipment sales growth
of 19%, versus likely carrier CAPEX growth of 15-17%.
We forecast the North American market will show more
deceleration than Europe, sales to new carriers will show
more deceleration than incumbents, and sales to wireline
carriers will show more deceleration than wireless.
The decelerating spending should affect all major
equipment categories, including optical and data net-working.
These categories grew nearly 65% in 2000,
accounting for 20% of total spending, and nearly 40%
of the growth in spending.
We are downgrading Cisco and Nortel from out-perform
to market-perform. We are also reducing our
2001 EPS expectations for Lucent and Motorola, but
maintain these stocks at outperform. We do not believe
the results of this survey will have material impact on
our projections for Palm and Nokia. Both stocks are
rated outperform.
The Capital Spending Survey
We surveyed some 59 carriers in North America
and Europe as to their capital spending plans for
2001. The results of our interviews clearly indicated
the intention of the world’s carriers to rein in capi-tal
spending that has risen to nearly 30% of indus-try
revenues. In aggregate, carriers expect to de-crease
spending 3% in 2001 after growing spending
31% in 2000, adjusted for currency effects (see Ex-hibit
1).
U.S. carriers reported an expected 9% reduc-tion
in spending, after growing CAPEX an esti-mated
36% in 2000 (see Exhibit 2). Projected
spending cuts are most acute in smaller and newer
carriers. Of particular interest, big-spending new
backbone networks — e.g., Level3, 360Networks,
Williams, Global Crossing — show sharp projected
declines of (25)%, although much of the planned
declines are the result of the completion of capital-intensive
trenching and cable laying. Nonetheless,
the triple-digit 2000 equipment spending growth of
this group is expected to decelerate sharply to less
than 20%. CLECs and ISPs are also projecting
sharp spending declines of (23)% for CLECs and
Exhibit 1 Global Carrier CAPEX
Total Global Carrier CAPEX (million)
1996 1997 1998 1999 2000E 2001E
European
(euro) 32,272 33,325 31,775 39,099 53,846 61,802
FX Rate
(Annual
Avg. Rate) 1.1743 1.1743 1.1743 1.0569 0.9277 0.8800
European ($) 37,896 39,132 37,312 41,322 49,955 54,386
North
America ($) 44,825 56,144 65,082 85,684 116,227 106,045
Total
Global ($) 82,721 95,276 102,394 127,006 166,182 160,431
YoY Chng. 13% 15% 7% 24% 31% (3)%
Source: FactSet, company reports and Bernstein estimates.
4 TELECOM EQUIPMENT: 2001 CARRIER EQUIPMENT SPENDING TO DECELERATE
BERNSTEIN RESEARCH SEPTEMBER 29, 2000
(35)% for ISPs. Incumbent carriers show the least
volatility in their spending patterns, and are pro-jecting
slight growth for 2001.
The European spending outlook is somewhat
better, mostly due to 3G-related spending by large
carriers (e.g., British Telecom, Deutsche Telekom,
France Telecom — see Exhibit 3). Year 2000 capital
spending growth of 38% (denominated in euros) is
expected to decelerate to 15%. However, when
adjusted for the decline of the euro, 2000 dollar-denominated
spending growth is expected to be
only 21%, decelerating to 9% in 2001. Furthermore,
most of the 2001 spending for 3G will be related to
cell-site acquisition and construction rather than
equipment purchases, somewhat offsetting the
more positive outlook. Spending by smaller Euro-pean
carriers is expected to decline 3% on average.
Since the results of carrier surveys have notori-ously
underestimated actual carrier spending in the
last three years, it is easy to write off these projec-tions
as irrelevant — easy, but we believe unwise.
Surveys in 1999 — generally limited to the largest
U.S. carriers — projected 2000 CAPEX growth of 7-
10%. Actual CAPEX growth now appears likely to
top 36% in the U.S. and 30% worldwide. Our survey
projects 2001 CAPEX to decline 9% in the U.S. and
3% worldwide. If we assume the degree of underes-timation
is the same, it equates to 18-21% CAPEX
growth in the U.S. and 17-20% growth worldwide.
A deceleration of this magnitude would have seri-ous
implications for telecom equipment stocks
trading at multiples more than double their growth
rate on the assumption of top-line acceleration.
It Gets Worse
Carrier spending levels in 2000 are truly extraordi-nary.
The 59 companies in our survey are growing
their revenues about 13% in 2000, which means the
average carrier is now spending more than 30% of
revenues on capital expenditures (see Exhibit 4). At
the current pace, CAPEX spending would exceed
carrier industry revenues in six years. The story is
more incredible when you consider that a consid-erable
part of the growth in reported revenues
comes from rapidly growing wholesale revenues,
which essentially get counted twice. For example,
wireless carriers report customer spending on long
distance as retail wireless revenues, while the long-distance
carrier reports the same sale as wholesale
long distance, or a new backbone carrier provides
incremental capacity for a long-distance provider
and both companies count the sale. Adjusting for
this effect suggests that actual retail telecom serv-ices
revenues are likely growing less than 10% a
year, and industry CAPEX may now be approach-ing
50% of total carrier retail sales.
Carrier market conditions, which contributed
to the huge increase in actual spending versus ex-pectations,
have deteriorated. Two CLECs — GST
Telecommunications and ICG Communications —
have become insolvent. Stock prices for every cate-gory
of carrier are down in absolute and relative
terms after three years of superior returns (see Ex-hibit
5). Free cash flows have turned sharply nega-tive
— only 4 of 41 U.S. carriers showed positive
cash flow during the first half of 2000, making it
painful to fund further CAPEX acceleration with-out
external financing. Bond yields are up more
than 100 bp from a year ago. Increased scrutiny of
equipment supplier balance sheets has made it
more difficult to secure vendor financing. In this
environment, we believe we are likely to see few
new-build network projects funded, more carrier
bankruptcies and a trend toward CAPEX un-friendly
industry consolidation.
As a result, we believe that carriers are unlikely
to exceed their 2001 CAPEX projections by as large
TELECOM EQUIPMENT: 2001 CARRIER EQUIPMENT SPENDING TO DECELERATE 5
BERNSTEIN RESEARCH SEPTEMBER 29, 2000
a degree as they did in 2000, causing us to make a
further adjustment. As a result, we believe 2001
industry capital spending growth is likely to fall to
13-17%. Of course, capital expenditures are not
only equipment spending. In 2000, there were bil-lions
of dollars spent by new backbone players to
lay fiber optic cables underground and undersea.
Carriers report these nonequipment expenditures
will be dramatically lower in 2001. While this im-pact
is partially offset by increased nonequipment
CAPEX by European wireless carriers acquiring
cell sites and building towers for 3G, we are tem-pering
our equipment spending forecasts relative
to these CAPEX projections. We estimate global
2001 equipment spending will grow about 19%,
versus the more than 28% equipment spending
growth apparent in 2000 (see Exhibit 6).
Nowhere to Hide
While 19% spending growth is still above historical
averages, the 900 bp industry deceleration would
make it difficult for any sizeable competitor to de-
liver on expectations of accelerating or even sus-taining
their 2000 top-line growth rate. We believe
that the impact of decelerating spending will be felt
in all equipment categories. We do not believe op-tical
equipment or data networking gear will be
immune from the effect of deceleration, despite
their relative priority in spending plans. Given that
these categories already constitute more than 20%
of industry telecom equipment spending and 40%
of industry growth, carriers must decelerate
spending in these areas to have any hope of keep-ing
CAPEX to a level they can afford. We believe
spending growth on optical equipment and data
networking will fall from more than 60% in 2000 to
less than 40% in 2001.
Many argue that only traditional voice teleph-ony
will be affected by the deceleration. We dis-agree.
Spending on traditional voice networks is
now less than 20% of the total, making it an un-likely
source for all 900 bp of deceleration. Fur-thermore,
the demand for voice services is still
growing and providing much needed profits,
making it unlikely that the industry will cut
spending on traditional switching significantly
more than the 9% decline assumed in our industry
model.
Wireless will also see deceleration, although to
a much lower degree than most other categories.
We believe that 3G equipment spending will begin
later than many assume and is likely to be smaller
as well due to more limited deployment plans and
lower prices. Moreover, much of the 3G-related
CAPEX in 2001 will go towards cell-site acquisition
and construction rather than equipment. We proj-
Exhibit 5 Total Returns of U.S. Telco Stocks
1994 1995 1996 1997 1998 1999
2000
6 TELECOM EQUIPMENT: 2001 CARRIER EQUIPMENT SPENDING TO DECELERATE
BERNSTEIN RESEARCH SEPTEMBER 29, 2000
ect wireless equipment spending growth to go
from 35% in 2000 to 29% in 2001.
We believe the most attractive network equip-ment
sector is likely to be software. Given the very
poor financial and stock market performance of the
carrier industry, the primary consideration for serv-ice
providers is attracting revenue and improving
profitability. The key is delivering value-added
services and new applications to attract customer
dollars — not expanding capacity for commodity
traffic. In particular, we believe carriers will focus on
improving provisioning and billing systems in re-sponse
to real customer complaints. As such we are
projecting only minor deceleration — from 28%
growth in 2000 to 27% growth in 2001. Companies
that could benefit from this are Amdocs ($62), Portal
($38), CompTel ( 17), MicroMuse ($199), Soft-ware.
com ($193) and Visual Networks ($76).
Not Every Company Can Exceed Average
Current 2001 consensus EPS expectations for a uni-verse
of 143 communication equipment companies
assume an average 28% increase versus 2000 (see
Exhibit 7). If our projection of 19% industry revenue
growth is close to accurate, it is likely that a majority
of these companies will disappoint in 2001 — and
even if numbers can be achieved via expense re-ducing,
the stocks will suffer. We are particularly
concerned about the elite optical and data suppliers,
which carry P/E multiples more than twice their
earnings growth rate. We do not believe these stocks
will be able to sustain their valuation if sales growth
is decelerating.
Risks
Our perspective on telecommunications carrier
spending is at risk to a significant upturn in the
health of the service-provider community. If carriers
can demonstrate significant new revenue streams
and accelerate their own top-line growth, access to
capital and the willingness to spend it could be suf-ficient
to sustain spending growth near 2000 levels
for another year. While current conditions suggest
this scenario is improbable, it is not impossible.
It is also possible that carriers could continue
to spend at 2000 growth levels despite the unfavor-able
conditions. In this case, we believe that we
would see many carriers fail and others consoli-date,
eventually yielding the expected deceleration.
Moreover, our belief that optical and data
spending will also see significant deceleration also
could be early. In this case the relative mix of
spending would tilt even more sharply to these
categories in 2001, with corresponding negative
effects on other categories. We believe this is un-likely,
as the new backbone carriers that have been
key drivers of optical spending have very little
CAPEX in the traditional categories. In a positive
scenario, the key equipment stocks could regain
the 20-30% lost in the recent downturn.
Investment Conclusion
Consensus expectations for a universe of 143 net-working
companies project aggregate 2001 earn-ings
growth of 28%. Given our estimate of less than
20% sales growth, we believe that it is highly likely
that many of these companies will fail to meet ex-pectations.
In particular, we are concerned that
companies trading at prices more than 50 times
forward earnings will face considerable pressure in
an environment of decelerating sales. We recom-mend
reducing investment weight in this sector,
and favor low-P/E stocks with valuation support
— Lucent ($31), Motorola ($28) and 3Com ($18) —
and handset/PDA vendors not dependent on car-rier
CAPEX — Nokia ($40) and PALM ($52), all
rated outperform. Cisco ($59) and Nortel ($61)
have been reduced to market-perform based on
likely top-line deceleration. Ericsson ($15) is rated
underperform.
Paul Sagawa (212) 407-5825
psagawa@bernstein.com
Matthew Nagle (212) 756-1855
naglemr@bernstein.com |
