The Bandwidth Cycle
08-Jun-01 00:20 ET
[BRIEFING.COM - Gregory A. Jones] Everyone knows to trade the semiconductor cycle; so much so, in fact, that semi stocks have traded up sharply this year solely on the hope that a bottom might be found in the second half of the year. But with the shift from the processor paradigm to the bandwidth paradigm still in its relative infancy, few investors seem to be considering the possibility that bandwidth might also be a cyclical investment phenomenon. For those who do believe in a bandwidth cycle, the long-depressed telecom carriers are suddenly looking like a good bet.
Past Woes
The woes of the telecom carriers have been well documented. Without getting into great detail, here are a few of them:
Heavy debt burdens
Rabid competition due to a bevy of start-up service providers
Slowdown in both data and voice demand growth prompted by dot-com bust and general economic weakness
Networks that are growing in cost and complexity, requiring huge capital expenditures
Deployment difficulties for DSL service
Slow rollout of competition for local service
Future Positives
Undoubtedly, we have left about 20 other factors off this list, but this at least provides a taste of the headaches that have depressed the stocks of telecom carriers over the past year. In upgrading our view of the sector, we will not argue that every negative has suddenly turned positive - certainly DSL deployments remain a problem and local competition is still virtually nonexistent. But enough of these negatives are turning now or soon will that a more optimistic view of the telecom service sector is warranted. Let's run down a few of the positives.
Supply shrinking as emerging carriers fail
PSINet, Winstar, Teligent, NorthPoint, Advanced Radio, GST Telecom, ICG Communications, eSpire. If this were Jeopardy, you would now ask What is the telecom graveyard? The list of Chapter 11 filings grows longer, and there are many more to come. The debt burdens among emerging carriers are simply crushing, and revenues are not rising quickly enough to stave off many more failures. That's bad news if you invest in the losers, but good news if you pick the survivors.
Just as semiconductor companies overbuild capacity in good times and then suffer in bad, so too has the telecom sector. Soaring data revenues fuelled by the dot-com boom and readily available capital triggered a surge in capacity over the past few years. But now the capacity growth rate is slowing as emerging carriers fail or severely curtail expansion plans, and new entrants are non-existent.
In the semiconductor sector, stocks are bought even in anticipation of the downsizing in capacity. In the telecom sector, that downsizing started a year ago, and yet still no one wants to buy these stocks. But the dynamics are the same -- demand growth will speed up and slow down alongside the macro-economy, but the long term trend in the bandwidth demand is quite clearly up, and at a good clip. Growth in supply, meanwhile is slowing markedly. That's the point at which you want to buy the purveyors of bandwidth.
Equipment prices falling
The gloom of the telecom sector has been shared by carriers and equipment vendors alike, as the debt loads crippling the carriers have forced capex plans to be scaled back dramatically. But there is a silver lining here for the carriers that can survive the downturn. What had been a sellers' market for the latest, greatest telecom equipment is now a buyers' market.
Qwest (Q) has been one of the more forthcoming carriers regarding this shift. On April 24, Qwest reduced its capex plans for 2001 to $9.2 bln from $9.5 bln, and then on June 5, planned capex came down again, to $8.8-9.0 bln. In bringing down capex, Qwest has noted that it is not significantly scaling back equipment purchases, it is just getting the same gear for a lower price. We have heard supporting stories from the equipment vendors themselves, as gross margins declined across the board in Q1 due to pricing pressures.
If you are a Qwest or a Baby Bell that is cash flow positive and will survive the telecom shake-out, this is great news. The network can continue to be upgraded, thereby reducing future costs of supplying bandwidth, but the cost of the upgrades is coming down.
Long distance prices stabilizing
On June 1, AT&T (T) did something quite extraordinary. Ma Bell hiked its basic residential calling rates. The increase wasn't huge, and not many customers will be affected by it, but it was an increase. Anyone who held T, WCOM, or FON through the brutal price wars of the past few years was happy just to see the price-cutting stop. To see an actual increase of any magnitude is big news indeed. Here again, the troubles faced by new carriers are benefitting the old guard, as competitive pressures are no longer intensifying.
Incumbency and long-term viability becoming a competitive advantage
This is perhaps the most frequently overlooked positive factor for incumbent carriers. When a business is selecting a colocation facility, an ISP, a local phone carrier, or any other telecom service, the viability of the carrier is now a critical consideration. The costs of moving to another colocation facility or switching ISPs are considerably greater than zero, particularly if service is cut off with little warning.
Ask any CIO or CTO these days, and you will find that they are spending as much time looking at the financials of a potential carrier as they are looking at the service offering. This can be a self-fulfilling prophecy of doom for emerging carriers, and a key competitive advantage for incumbents.
Testing the Waters
Just as we undoubtedly left out some of the negative factors that depressed the telecom group in recent years, we have probably omitted a positive point or two. As we continue to follow this story in coming months, we will report on any other positive factors, and we will monitor the sector for evidence that the factors noted above are or are not coming to pass. But it's not too early to start to test the waters of the telecom service sector, as this group should outperform over the coming year.
In future briefs, we will delve further into individual stories, but we can at least provide a glimpse here of how the sector is shaping up. As we have noted, it will be critical to focus on the survivors. There will most likely be a few emerging carriers that recover and provide shareholders with great returns from current depressed levels, but we would not opt for these home run picks given the high risk of a complete loss. We would focus instead on the safer plays, because we believe they offer significant upside potential with far less risk.
The least sexy group is the Baby Bells, where SBC Communications (SBC) and BellSouth (BLS) look like better stories than Verizon (VZ).
More interesting are the hybrid incumbent/emerging carrier cos: Qwest (Q) and Broadwing (BRW), which offer the stability of local phone revenues and the upside of advanced fiber networks that can benefit from future growth in data traffic.
Long distance carriers Worldcom (WCOM) and Sprint (FON) are also worthwhile plays, and safer than debt-ridden AT&T (T).
New IXCs (interexchange carriers) are generally a risky bunch with heavily indebted names like Level 3 (LVLT) and 360Networks (TSIX), but Global Crossing (GX) still looks like a survivor.
Then there are the CLECs -- here is where you can probably hit a couple home runs, but we would steer clear of the risk.
As noted, we will go into these subsectors and individual names in future Stock Briefs, but this brief overview gets you started as we look to play the bandwidth cycle instead of the overplayed semi cycle. |
