DEAD ON OCTOBER 6TH AMAZING WORK!!
BERNSTEIN RESEARCH OCTOBER 6, 2000
Telecom Equipment Is a Cyclical
Business
Overview
The sky-high multiples granted the leading telecom
equipment vendors make it clear that investors expect
growth — a lot of it and for a very long time. Indeed,
consensus EPS estimates project more than 28% sales
growth for the entire sector in 2001 (see Exhibit 1), after
a similar performance in 2000. Our strategy services’
implicit growth-rate model suggests telecom equipment
companies would have to grow earnings over 20% for
the next ten years to justify today’s price levels (based
on a ten-year DCF). This is not reasonable, given that
only one company, IBM, has ever delivered such growth
over an extended period. For a whole industry to do it is
not credible. This sector includes at least 20 companies
with sales of at least $500 million and P/E ratios of at
least 50 times 2001 earnings. In aggregate, these com-panies,
with sales of $250 billion have a market cap of $2
trillion.
The breathtaking rush of spending resulting from
the cosmic alignment of Internet mania, carrier deregu-lation
and easy access to capital led the market to believe
that it could go on forever. However, there are signs that
the party may have reached its peak. Carriers have in-creased
their spending to $0.30 on every dollar of reve-nues,
more than double the historical rate, and have very
little to show for it. Retail carrier revenues are barely
growing 10% per year, and 90% of carriers show nega-tive
free cash flow, communally burning more than $50
billion per year.
We believe telecom spending is cyclical, just like
every other capital-equipment company business you
can think of. We believe 2000’s nearly 30% growth in
equipment sales is the likely peak (see Exhibits 2 and 3).
At current carrier revenue rates, CAPEX would stay
the same for five years before it would fall below 20% of
sales. Given the length and strength of this upcycle, it
would not be surprising to see a 3- to 5-year downcycle,
including spending drops in absolute terms a couple of
years out. The normalized growth rate for this industry
is likely less than 15%. We believe it is time to think
about trough evaluations for telecom equipment compa-nies.
Moreover, we recommend reducing weighting in
this sector and, in particular, its highest-flying names,
such as Nortel, Cisco and Ericsson.
The Free Internet
The Internet was designed to be free. Its original
purpose was to ensure robust, secure communica-tions
between Defense Department computers in
the event of the failure of any particular communi-cations
link. Because messages were broken into
small packets, and each packet was forwarded in-dependently
by each intermittent node in the net-work
until they were delivered to the intended
destination, it was impractical to meter usage on
the network even if it were desirable. The technol-ogy
was quickly adopted by the academic commu-nity,
and for many years was the province of sci-entists
who also saw no particular need to keep
track of who was using what for how long.
By the time Mosaic and the World Wide Web
opened the Internet to dummies, it was too big and
too complicated to think about keeping track of
usage. A single file transfer might involve thou-sands
of packets, each packet would be forwarded
as an independent object, likely over different
paths, each passing through dozens of routers,
each of which would have knowledge only of the
previous and next step in the chain. It was a lot
easier to offer an all-you-can-eat service. The oft-heard
phrase, “too cheap to meter” has a consider-able
resonance when one considers the cost of im-plementing
even rudimentary metering mecha-nisms.
As the Internet grew in prominence, free usage
shifted from a practicality to a birthright. Even if
the technology were developed to enable effective
usage metering, public sentiment would not allow
it. Failure to develop a workable technology for
triaging traffic into classes of service has stymied
attempts to develop premium services and charge
accordingly for them. “All-you-can-eat” is the
standard for the biggest corporation to the smallest
consumer user — the only difference is the size of
the pipe. The price elasticity of telecom services has
always been high, and faced with an incremental
cost of zero, users are sending and downloading
ever more information over increasingly long dis-tances.
Making It Up in Volume
As a result, Internet traffic has grown voraciously.
The largest U.S. carriers — i.e., WorldCom, Sprint,
AT&T, et al. — report data traffic has overtaken
voice traffic, with Internet Protocol (IP) outpacing
all other categories. Whether Internet traffic is
doubling every four months or every nine months
is impossible to say, since there are thousands of
individual networks that make up the Internet, and
no public metrics to keep track of who is sending
how much how far. Nevertheless, anecdotal evi-dence
supports the generally accepted assertion
that Internet traffic has been growing more than
100% per year and now makes up more than half
of total communications volume.
Not surprisingly, Internet service revenues
have not kept pace. Telecom revenues from data
services, of which Internet revenues are a large
subset, are growing at much less than half the rate
of traffic. We estimate that retail data service reve-nues
are growing about 38% in 2000, and will show
decelerating growth of about 24% on average over
the next four years. Combined with growing wire-less
and sluggish wired voice revenues, total in-dustry
revenue growth appears to have plateaued
in the low teens.
Competition Rears Its Ugly Head
The rise of the Internet was not the only telecom
industry discontinuity of the past decade. Global
deregulation and privatization opened the door to
new competitors. The capital markets opened the
floodgates, providing tens of billions of dollars to
upstarts looking to build new local and long-haul
networks from the ground up. For the thousands of
CLECs and dozens of regional and national fiber
optic backbone builders, the Internet was and is the
modern-day equivalent of the Oklahoma land rush
— price low, take share and ask questions later.
Later is now. After a five-year ride of easy
money and soaring stock prices, the carrier indus-try
is under severe pressure. The free Internet does
not pay the bills. Only 4 of 40 large U.S. network
operators we surveyed showed positive free cash
flow in the first half of 2000, cumulatively on pace
to burn more than $50 billion in cash for the year.
Fierce competition, the inability to differentiate
services, and customers’ sense of entitlement to
free Internet made price hikes untenable. Carrier
Exhibit 2 Data, Optics, Software and Wireless — The “Hot” Areas of the market
stock prices have dropped an average of 40% year-to-
date, with the biggest carnage observed in the
smallest and newest carriers (see Exhibit 4). The
cost of debt has also risen sharply for those carriers
even able to float a bond issue. Three high-profile
CLECs have gone bust, selling network assets for
dimes on the dollar, with others likely to follow.
Déjà Vu All Over Again
The precarious state of the carrier industry is par-ticularly
volatile given the size of the bets on the
table. Over the last five years, at least eight national
optical backbone networks have been built from
scratch, for a combined investment of more than
$50 billion. These networks are just coming online
now. The impact of this capacity is evident in the
market price, which has been dropping 40% per
year. We believe these price declines will accelerate
with these new networks. The U.S. carrier industry
CAPEX is growing 36% in 2000 (see Exhibit 5), and
is nudging above 28% of total carrier industry
revenues (see Exhibits 6 and 7). At current growth
rates, CAPEX would exceed revenues within five
years. There appear to be only two ways to stanch
the bleeding: boost revenue growth via yet unfore-seen
services and price hikes; sharply decelerate
spending; or most likely both, as the first is im-probable
without the second.
This scenario should raise an eerie feeling of
déjà vu for technology investors. Every few years,
semiconductor companies pour capital into new
6 TELECOM EQUIPMENT IS A CYCLICAL BUSINESS
BERNSTEIN RESEARCH OCTOBER 6, 2000
capacity chasing a wave of new demand. By the
peak of the semiconductor cycle, CAPEX typically
reaches 30% of industry revenues, followed by a
period of steep spending deceleration, coinciding
with a general deterioration in the health of the
semiconductor companies and a corresponding hit
to stock prices. Eventually demand overtakes ca-pacity,
spurring another upcycle.
Telecom carriers and their vendors are dancing
to the same tune as the semiconductor industry.
The deregulation of the global service provider
market, combined with the simultaneous rise of the
all-you-can-eat Internet and the almost limitless
supply of capital to attack the opportunity, has cre-ated
an upcycle that is longer and stronger than
anyone could have imagined. Nevertheless, tech-nology
has failed to deliver the magic bullet that
might enable carriers to grow their way out of this
serious situation. The growth and profitability of
telecom service providers no longer supports the
current level of spending.
What Happens Next
The higher the peak on the upside, the greater the
pain on the downside. We believe the carrier in-dustry
will rationalize, with the consolidation of
many competitors and the failure of weaker hands
leading to reduced CAPEX and, eventually, to
higher prices. As such, the deceleration and
equipment spending we have projected for 2001 is
not a one-year perturbation, but a cyclical down-turn
likely to persist until demand and capacity
equilibrate at a price that allows carriers to earn
attractive returns and generate cash. This adjust-ment
is likely to take 3-5 painful years. That means
that capital spending growth, and, by implication,
equipment-spending growth, will dip below serv-ice-
provider revenue growth for a similar period of
time.
This means hard choices. Capacity expansion
will be reined in, particularly in the free Internet
market — meaning deceleration in optical equip-ment
and data networking gear. Spending priority
will shift to the support system and application
software that might allow carriers to differentiate
their services and earn better returns. Software and
hardware to enable true access of service, enforce-able
across carrier boundaries, remain elusive Holy
Grails, and for many technical reasons, we are not
hopeful that a solution is forthcoming anytime
soon.
What Could Go Wrong
There are two major risks to our bearish perspec-tive.
First, new technology advances could enable
value-added services that could increase carrier
revenue growth and profitability. While we do not
believe this factor changes the long-term cyclicality
of telecom equipment spending, it could forestall
deceleration for a year or more. We believe this is
unlikely given our research, but such a scenario
could yield a much less abrupt deceleration and
continued outperformance for leaders.
Second, carriers could decide to continue the
extraordinary spending growth despite the warn-ing
signs we have detailed. In this scenario, short-term
equipment spending growth could be sus-tained
a while longer, but the end result appears
likely to be widespread carrier bankruptcy and
defaults on billions of dollars of telecom debt, in-cluding
significant debt held on equipment ven-dors’
balance sheets. While telecom equipment
shares might hold on to rich valuations longer, we
believe the fall would be all the more painful.
Investment Conclusion
Investors should begin to evaluate telecom equip-ment
stocks as cyclicals that appear to have passed
their peak valuations. As such, we believe that it is
prudent to underweight telecom equipment stocks
heading into 2001. However, strong second-half
2000 earnings for the sector are likely, as carriers
spend out their 2000 capital allocations. We believe
these strong earnings and bullish forward-looking
comments from markets (despite murky visibility
beyond three months) will yield misplaced opti-mism
and a corresponding rally in telecom equip-ment
names. We would view any such run as an
opportunity to reduce holdings in highly-valued
companies such as Nortel ($66), Cisco ($57) (both
rated market-perform) and Ericsson ($15) (rated
underperform).
We would prefer equipment stocks that al-ready
appear to trade at near-trough valuations —
e.g., Lucent ($33), Motorola ($28) and 3Com ($20)
(all rated outperform). We also remain positive on
consumer-driven stocks — e.g., Palm ($45) and
Nokia ($39) (both rated outperform) — which feel
little impact from the carrier spending cycle.
Paul Sagawa (212) 407-5825
psagawa@bernstein.com
Matthew Nagle (212) 756-1855
naglemr@bernstein.com |
