Telecom equipment makers sail along Sutro analyst sees more good times as 21st century nears
By Jeffrey Bartash, CBS MarketWatch
Last Update: 1:13 PM ET Dec 11, 1999
NewsWatch
WASHINGTON (CBS.MW) -- The telecommunications equipment market is
soaring these days as phone and data carriers move to modern Internet-based
networks that use "packet-switched" standards and away from century-old
circuit-based networks.
Digital, packet-switched networks are faster and more efficient than analog,
circuit-based networks. They can handle far more video, voice and data
information that individuals and businesses are increasingly sending over
phone lines and computer networks.
CBS.MarketWatch.com spoke with Patrick Houghton, an equipment analyst
at Sutro & Co., about Year 2000 concerns, industry competition and future
growth prospects for his industry.
CBSMW: Is the so-called Year 2000 computer bug likely to have much
effect on equipment makers in the fourth quarter or beyond?
Houghton: I am anticipating a really strong fourth quarter. I think, if anything,
you?ll see an exacerbation of the typical fourth-quarter spike and first-quarter
letdown. Usually you see a lot of year-end spending by telephone companies
for equipment. Then you usually see a soggy first quarter. I think you?ll see
more of that this year.
The reason is that the telecommunications carriers (telcos) are seeing a
tremendous increase in demand for bandwidth. They are not going to want to
be sitting there in January wondering what happened to their order for
switches or whatever. I think there is going to be some acceleration in
spending in the fourth quarter ahead of Y2K, and then you?ll see higher
inventories at the telcos and probably a softer first quarter for equipment
suppliers. Overall, the trends for telecom are very solid. I think this is going to
be a very minor blip.
CBSMW: Cisco Systems (CSCO: news, msgs), which just became the
third U.S. company to surpass $300 billion in market capitalization, is
seen as the 900-pound gorilla in the telecom equipment industry even
though it?s far from being the biggest supplier. What accounts for this
phenomenon?
Houghton: Cisco may not be the biggest, but it?s the most profitable, and it?s
getting very close to being one of the biggest. They just closed fiscal 1999 in
July at over $12 billion in sales. I am looking for almost $17 billion in fiscal
2000 and $22 billion in 2001. We?re talking about by July 2001, they will be
Nortel?s (NT: news, msgs) size. And on the way to Lucent?s (LU: news,
msgs) size.
What you are paying for here with Cisco is growth. I can?t think of any
company in history that has grown the way Cisco has. It?s not just that
they?ve been maintaining growth rates. They accelerated growth in the past
few quarters. I see this continuing because they are going after a different
market now. Their prior growth story has been enterprise (corporations).
That?s been slowing. But the telco market opens up a huge new opportunity.
They are going from a $30 billion corporate data communications market to a
north of $200 billion telco market. Now part of that market is not going to be
addressed by Cisco, but there?s still probably north of $100 billion for them to
go after.
CBSMW: Aside from Cisco, the other two of the
Big Three among telecom equipment suppliers in
North America are Lucent and Nortel. Can they
keep up with Cisco, technologically or otherwise?
Why or why not?
Houghton: I think they can. I think they have
demonstrated that. Nortel is the leader in optics.
Lucent is a very close second. That?s the challenge
for Cisco ? and that?s why they bought Cerent for $7
billion. But Cerent has very small revenue compared to
Lucent and Nortel. The optics is the single fastest
growing market in telecom. Nortel and Lucent are the
two leaders.
The second major growth area is wireless, which is
not materially participated in by Cisco. Cisco has a
partial investment in a wireless company with
Motorola (MOT: news, msgs), and they recently
bought Aironet for wireless local area networks, but
that hasn?t been a real big business for them. It?s a
very sizable business for Nortel, probably a good 15
percent to 20 percent of revenue. And it?s pretty close
to that for Lucent as well.
If you are looking for major themes to invest, I think optics is one. Wireless is
another. The third theme is the transition from circuit-switched networks to
packet-switched networks. This is probably Cisco?s biggest opportunity right
now. Cisco doesn?t have any revenue in circuit switches. Nortel and Lucent
probably each have 20 percent of their revenue in narrowband voice switches.
I would certainly expect Lucent and Nortel to get their fair share of this
next-generation packet-switched market. However, Lucent and Nortel have a
big chunk of revenue at risk in the circuit-switched. While you?re still going to
see growth for these companies, you?re going to see that tempered by slower
growth in the circuit-switched business. Cisco doesn?t have any
circuit-switched business to cannibalize. So it?s going to be a pure growth
opportunity for them.
CBSMW: You?ve explained the dynamics in the market for
packet-switched gear. Can you expand on optics, the fastest growing
market.
Houghton: Optics. Instead of sending electrons down copper wire, you put
photons down glass. There are a number of layers. The most obvious layer is
the physical glass that gets put down along the ground, or along railroad
tracks, or highways. This is produced by Corning (GLW: news, msgs) and
Lucent, the two major producers of optical fiber. The next layer is putting
those photons over the optical fiber. Those are companies like JDS Uniphase
(JDSU: news, msgs), SDL Inc. (SDLI: news, msgs), Ortel (ORTL: news,
msgs). Then you have the companies that use the components to put together
the systems that put signals over those optical fibers. The obvious ones are
the Lucents, the Nortels, Tellabs (TLAB: news, msgs). Then you have
emerging players like Sycamore Networks (SCMR: news, msgs).
What?s causing the trend in optics is the explosion of bandwidth. The thing
driving bandwidth has been business customers. Going forward it will be
consumers. Right now most users connect to the Internet via their phone
lines; 56K is the best you can get. As you go to cable modems and high-speed
DSL phone lines, now you are going to 6 megabits. As you go from tens of
thousands of subscribers using this kind of bandwidth to millions of
subscribers, that?s going to multiply the capacity required. That means more
fiber optics.
CBSMW: Which public companies do you think are the best or most
likely acquisition targets?
Houghton: I think Ortel trades at a significant discount to almost all the other
optics companies. They have very good technology. Another company that
could be an acquisition is P-Com (PCMS: news, msgs). It?s had some tough
times, but they do have some good point-to-multipoint technology for the
wireless-access market. The only other public competitor is Netro Corp.
(NTRO: news, msgs), and they are trading at a significant discount to Netro.
CBSMW: There?s a saying among investors that when there?s a war
going on, you should buy the stocks of the companies that sell the
bullets. Well, there's a war going on among phone carriers for your
business and mine. Lots of people have been buying shares of the arms
suppliers, the telecom equipment makers. Is the sector oversold or not?
Houghton: I think there is still more room to grow. The reason why you are
seeing these kind of multiples is because investors are looking for places to
invest where they can buy growth. Cisco, which is a relatively new company,
has a $300 billion market cap. But what would you rather own? General
Electric (GE: news, msgs), which is selling for 45 to 50 times next year?s
earnings per share, with its (slower) growth prospects? Or would you rather
own Cisco, selling for 70 times next year?s earnings, with growth potential of
35 percent to 40 percent? And generating $1 billion in cash per quarter.
CBSMW: What are the pitfalls you think investors should be aware of
when investing in telecom equipment makers?
Houghton: I think the biggest pitfall is market risk. Telecommunications
carriers are ones who go in for a lot of debt financing. Low interest rates
mean they can spend and build out their networks and buy capital equipment.
So if interest rates go up, the market is going to tank. And No. 2, the service
providers like the Qwests, Level 3s, the MCI WorldComs, the AT&Ts, have
less borrowing capacity. Then they have less money to spend on equipment.
CBSMW: We?ve talked about companies and industry segments you like.
Are there there any market segments you think investors should stay
away from?
Houghton: In the telecommunications market, areas that are going to be
declining are companies that are focused on circuit-switched equipment,
older-style circuit and analog equipment. More of the voice processing
equipment is going to be going primarily to packet-based solutions, away from
circuit-switched solutions. |
