a little bit more in depth to sink your teeth into
Wireline Networking Equipment - July 11, 2002
Page 2
Please see the important disclosures at the end of this report.
The Latency Fallacy
Summary and Investment Conclusion
In recent days we?ve received numerous calls from
investors wondering whether it is time to buy the optical
stocks, particularly the optical component stocks. Their
argument is not about valuation (that?s a different story), but
about recovery in demand. Here?s how it goes:
Data traffic continues to grow at 60-110% per year, but
carriers have dramatically reduced investment in their
networks over the past year. Many carriers are now
experiencing increased latency - constant delays in
transmission - on their networks. To maintain quality of
service, these carriers will be forced to re-invest in their
networks. The resulting increase in spending will benefit
the optical systems vendors (Alcatel, Ciena, Lucent, and
Nortel) but even more so the optical component vendors
(Agere, Corning and JDS Uniphase) who are most
leveraged to a recovery in demand. So now is the time to
buy the optical component stocks!
We strongly disagree with this view; our industry view on
telecommunications equipment is Cautious, and not without
reason. The ?Latency Argument?, we think, is flawed on
multiple levels. Here are the problems we see with it:
First, we don?t think network latency is an indicator of
rising capacity utilization for optical equipment. Optical
?transport? equipment in most networks - SONET and
dense wave division multiplexing (DWDM) gear - is
designed to guarantee delivery of voice and data by
delivering slots of traffic in strict rotation. There is
generally no latency at this level of the network. SONET
gear, for example, does not include the kind of buffering
seen in IP routers. Instead, latency is a phenomenon at the
IP layer. So increased network latency may be a lead
indicator of demand for IP routers, but certainly not for
SONET and DWDM equipment and optical components.
In fact, many carriers tell us they still have a glut of optical
transport capacity on their networks.
Second, even if latency on some routers is rising, the
linkage between rising traffic and carrier spending is
unclear. Over the last 12 months, we?ve seen carriers
redeploy equipment and line cards from routes with excess
capacity to routes in need of added capacity. True, that
substitution can?t last forever. But it can delay a rebound in
spending and play havoc with short term revenue
projections.
Third, capacity utilization fluctuates dramatically as carriers
consolidate. Wholesale carriers have told us that their
estimates of network capacity utilization plummeted when
their carrier customers stopped leasing bandwidth, either
due to bankruptcy or an attempt to bring traffic ?on net?.
Many carriers lease far more capacity than they fill with
their own customer traffic, so when they go under and their
customers migrate to other networks, the net effect is to free
up large amounts of bandwidth in the network. We believe
that there is further consolidation to come in the carrier
group; if that is true, capacity utilization could be a moving
goal post.
These three arguments make us skeptical of the linkage
between latency and demand for optical gear. But our
greatest concern with the latency argument is more
fundamental. In the post-bubble world, corporate
investment is no longer driven by traffic growth, page
views, minutes of use or number of subscribers. We believe
spending is driven by one metric only: expected return on
investment. We believe that one of the implications of the
alleged Worldcom fraud is that by mis-classifying operating
expenses as capital expenses, Worldcom overstated the
profitability of its enterprise data and internet backbone
businesses. Return on investment was even poorer than
originally thought. Carriers will likely spend more on their
networks not when latency rises, but when return on
investment in data networks rises.
For this reason, the Morgan Stanley Telecom Equipment
team forecasts aggregate revenues for our stocks based on
capital spending forecasts (driven by financial metrics) from
our service provider analysts. Those spending estimates
continue to fall as carrier profitability is squeezed by excess
competition, a weak economy, and deteriorating carrier
credit ratings. This is particularly true for the largest North
American interexchange carriers (AT&T, Qwest, Sprint,
and Worldcom), which dominate spending on (yes, you
guessed right) optical transport gear and by extension
optical components.
Investors have learned the hard way that the ?Latency
Argument? is a fallacy. In April 2001, Nortel CEO John
Roth predicted that spending on optical gear would
imminently recover as major North American carriers
reached maximum capacity utilization on their networks.
It?s now 15 months later, and we?re still waiting for the
recovery? |
