SMARTMONEY.COM: Cisco Can You Spare A Dime?
Dow Jones News Service ~ March 20, 2001 ~ 7:52 pm EST
By Roben Farzad
NEW YORK (Dow Jones)--By now, the argument against telecom-equipment stocks like Cisco Systems (CSCO), Nortel Networks (NT) and JDS Uniphase (JDSU) has started to take on a life of its own.
It goes like this: After a wild frenzy of Internet-related spending over the past couple of years, the nation's fiber-optic backbone - the pipe laid to carry those billions of bytes of Internet data - has become badly overbuilt. There's suddenly too much broadband capacity chasing too little demand. And that is driving down the price of transmission, which in turn is flattening revenue and cash flow for all manner of competitive local exchange carriers, or CLECs, Internet service providers, or ISPs, and voice data start-ups - not to mention the big boys like AT&T (T) and WorldCom (WCOM).
The end result: A rude interruption in what many saw a year ago as an uninterruptible stream of orders for the conventional and optical-networking gear produced by Cisco, Nortel et. al. Those 50% growth rates? Forget about it this year. Those fat earnings multiples? Still sinking fast.
The question for investors, of course, is how long the problem will last. And as Cintra Scott discussed in a story last week, that's a matter of considerable debate. While there appears to be plenty of consumer interest in broadband services, only 3% of the nation's homes are wired to get them. In other words, we face a bottleneck - there's overcapacity in the fiber backbone and undercapacity in the high-speed cable and DSL lines that enter the home. How soon the bottleneck will open is the $64 billion question.
The Squeeze Is On
In the meantime, however, the squeeze is creating pain for the industry that will very likely deepen in the months to come. For evidence we turn to a recent report on capital spending by Sanford C. Bernstein analyst Paul Sagawa. Now it's true that Sagawa may be the most bearish telecom analyst on Wall Street these days. But unlike several months ago when he was a lonely voice indeed, much of the rest of the Street has similarly doleful short-term outlooks. We figure he's worth listening to.
Sagawa's thesis is pretty straightforward. "The spending binge is now turning into the mother of all hangovers," he wrote in a February report. In 2000, Sagawa says, capital expenditures by the telecom-carrier industry grew a colossal 39% as companies like Allegiance Telecom (ALGX) and WorldCom bought routers and optical switches at a breakneck pace from companies like Cisco and Nortel and deployed them in networks across the nation. Trouble is, revenue from those networks grew only 11% last year, meaning a big chunk of those capital expenditures had to be financed with debt.
How much debt? A colossal amount. Sagawa figures the companies he covers burned through about $50 billion in cash last year to cover their spending after using up $9 billion in 1999. To fund it, they increased debt by $70 billion to a total of $310 billion. That works out to about 91% of industry sales - an extremely heavy load even in the best of times. With the capital markets closed for business, that sort of leverage is untenable.
Not surprisingly given the circumstances, carriers have told the Street that they plan to reduce capital spending this year by 7%. Since they habitually underestimate those costs, Wall Street analysts are speculating that they will actually try to increase spending by about 10%. If they stick with a 7% decline, Sagawa figures, they will still have a cash shortfall of $38 billion. If they increase by 10%, they will run a full $60 billion short.
Telecom Darwinism?
Where will the money come from? Sagawa offers no solutions. "The capital markets are saying 'No Mas!,'" he told clients in February. "It is not certain that $40 to $60 billion in external financing is available to an industry that collectively holds debt equal to 91% of its total sales." He notes that these companies could reduce spending by 20% and reach equilibrium with revenues - thereby ending the cash burn. In any event, under the best-case scenario (which seems iffy at best), spending will shrink from 39% growth in 2000 to a maximum of 10% growth in 2001, making life very difficult for the equipment companies who benefited mightily last year. "I doubt there's anyone who suggests that growth can be stronger than [the 7 to 10% range]," agrees Lehman Brothers large- cap telecommunications analyst Blake Bath. "There just isn't any money out there."
One of the biggest problems the equipment vendors face is that established incumbent carriers like SBC Communications (SBC) and Verizon (VZ) only account for 58% of the total projected carrier spending outlays for 2001. The rest of the pie belongs to smaller CLECs, ISPs and wireless providers with even less stable funding outlooks. They're in a fight for survival that promises to alter the face of the industry over the next several quarters.
"We're in the middle of a game of musical chairs," says Melinda Bond, president of the Bond Telecom Group, a St. Louis firm that pairs small local carriers with Regional Bell Operating Companies, or RBOCs, and other large firms. And while Bond and others agree that the end result will be a healthier industry, the intervening process is likely to be ugly. It could easily disrupt 2001 spending even more than Wall Street thinks. Consider a few examples.
In January, Atlanta-based Cypress Communications (CYCO), announced a series of drastic cost cuts in a bid to survive in the difficult climate. Cypress was once a promising provider of telecom services to office towers, but has seen its stock plummet over 97% in the past 52 weeks. In a bid to extend its existing funding into the second quarter of 2002, the company narrowed it focus to the less capital-intensive retail market and plans to lay off 40% to 45% of its staff by midyear. As a result, the company now expects to spend only $28 million on its network deployment in 2001 compared with Street estimates of three times that amount.
The National Bank of Cisco
Historically, private placements have provided a much needed source of capital for fledgling companies who were not established enough to tap the public markets. Lately, however, this alternative route has emerged from the corporate first-aid kit as a last-case financing resort for struggling public carriers. Not that it's very lucrative.
With its shares down from $97 in March 2000 to $3.50 when it made the announcement, Vienna, Va.-based CLEC Teligent (TGNT) revealed on Dec. 8 that it had obtained a $250 million funding commitment from Rose Glen Capital Management. Great news at first sniff - until you read the desperate terms of the complex agreement: Whenever Teligent should need it, Rose Glen will purchase common shares at a 5% discount to the volume-weighted average share price over " a pricing period." Teligent also agreed to issue warrants with a strike price 20% higher than an average market price at signing of any shares placed. If the company has to tap the facility, it could add as much as 40% dilution to its already pulverized shares - which have since plummeted to $1.50. Either way, Teligent, which is at best funded into late 2001, is in no position to reaccelerate capital spending.
Another funding route for cash strapped carriers is to turn to the equipment vendors themselves. Cypress, for instance, recently inked a $6 million lease facility with Cisco to fund a portion of its capital-spending requirements. Indeed, the vendors have been financing an ever growing number of customers: Sagawa estimates their on-balance sheet exposure at around $20 billion and it could be even worse. The Bernstein analyst points out that the vendors have even been syndicating loans to their financial partners so that the debt doesn't necessarily show up on their balance sheets.
This practice, of course, is more than a little risky for the vendors. Consider that if a customer they've financed falls into bankruptcy they not only lose the revenue, but they also lose the proceeds from the loan. For that reason, Sagawa makes the case that no matter how aggressive they get, they can't finance $40 billion to $60 billion in new spending. Investors and syndication partners, he supposes, simply won't allow it after a point.
'Kill or Be Killed'
And that brings us to the musical-chairs scenario. Given the financing difficulties, it's highly likely any number of small carriers will bite the dust this year. As we noted, that could be a good thing for the industry long term. But it won't be without its pain and disruption.
Take the case of bankrupt DSL enabler Northpoint Communications (NPNTQ). It thought its prayers were answered when Verizon agreed in August to buy 55% of the company for $800 million, including a badly needed $350 million in interim financing. But after realizing that its acquisition was saddled with a heavy load of nonperforming accounts, Verizon bailed out of the deal - even after already having funded Northpoint to the tune of $150 million. Now the DSL provider (whose shares are trading at around 17 cents each) is suing Verizon for $1 billion and is auctioning its assets. "It is our hope to sell the company as a whole, but we can not speculate on the outcome of this structured sale process," said Chief Executive Liz Fetter.
The legacy of this botched transaction? It may be a template for telecom Darwinism. What's to keep other survivors from running out the clock to buy bankrupt assets at fire-sale prices? After all, with many public carriers trading at almost half of their year-2000 lows, it certainly pays to be a vulture. And Lehman's Bath points out that as the scavengers pick over their carrion, a lot of second-hand inventory will be recycled through the system, further delaying new orders.
(MORE) DOW JONES NEWS 03-20-01
07:52 PM SMARTMONEY.COM: Cisco Can You Spare A Dime? -2-
That said, there's no doubt stronger competitors will eventually make for a more stable environment. "It's kill or be killed right now," said one technology portfolio manager at a recent Merrill Lynch conference. "But the shakeout will inevitably produce stronger, consolidated players that have a better case for access to capital." What investors need to recognize is that given this capital crunch, it will take time to arrive at that equilibrium.
It will come, however. It's worth noting that cable companies and Internet service providers like Earthlink (ELNK) still report that they can't roll out residential high-speed access fast enough. On the commercial front, many firms are still scrambling to wire their new digs with a T1 line. Accordingly, only 5% of the U.S. population and 1% of the world's population are broadband equipped today. That will change. And if the economy improves later this year or next, it may happen faster than we expect.
Even Sagawa admits the funding environment could improve. "The capital markets could open dramatically," he says, "perhaps driven by interest rate cuts." That's certainly something to keep an eye on. If a few big telecom deals get done it could light a fire under some of the equipment stocks.
Does that mean you should run out and buy? Only if you can afford the risk. The better strategy is to simply hold fire and be watchful for signs of a recovery. Sagawa's only picks at the moment among the equipment vendors are those so beaten down and maligned, they aren't likely to fall much further: Lucent (LU), 3Com (COMS) and Motorola (MOT). As for the Cisco's and JDSU's of the world which are down in the 70% range, "we give the same advice our mothers gave when we asked if we could go back in the pool immediately after lunch - WAIT," Sagawa says.
Mother may be right this time.
For more information and analysis of companies and mutual funds, visit SmartMoney.com at smartmoney.com
(END) DOW JONES NEWS 03-20-01
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