Heard on the Street September 8, 2000
Investors Worry Telecom Woes
Will Hurt Equipment Suppliers
By SUSAN PULLIAM and SCOTT THURM
Staff Reporters of THE WALL STREET JOURNAL
What goes up in tandem, it serves to reason, would come down in tandem.
That is what has gotten some investors worried this week about Internet
infrastructure stocks. The problem? Telecommunications companies have
hit a rough spot, and their stocks show it, with many way off 52-week
highs. Meanwhile, equipment suppliers, whose success was fueled in large
part by the robust spending of the telecoms, are still at nosebleed
valuations.
Now the question: Will the troubles of the telecoms bring down the
equipment suppliers -- Cisco Systems, Nortel Networks, Juniper
Networks, Sycamore Networks, to name just a few -- that have thrived
on their growth?
Behind the swoon in telecom stocks is slowing revenue in the companies'
traditional businesses and financing problems among the upstarts. That is
causing investors to wonder if the next shoe to drop is a slowdown in the
growth of spending by these companies for equipment for the Internet
build-out.
The question of a potential slowdown in equipment spending has been
kicking around Wall Street for several months. Some analysts say it is one
of the reasons that shares of Cisco, until recently the undisputed market
leader, have drifted sideways since late spring.
This week, however, such concerns came front and center after Ciena, a
supplier of fiber-optic equipment to telecom companies, reported it will
take a fourth-quarter charge as a result of a bankruptcy filing by one of its
clients, a European telecom carrier. Its shares fell 6% on the news.
The same day, a Morgan Stanley telecommunications analyst, Simon
Flannery, warned clients that increases in capital spending by telecom
companies may slow next year from about 30% this year to a figure more
in line with single-digit revenue growth at those companies. Other
equipment-manufacturers' stocks have slipped a bit on the news, including
Sycamore Networks, which fell on the Nasdaq Stock Market from an
opening on Tuesday at around $135 to $122.88 Thursday, while Juniper
Networks fell from an opening price of $221 on Tuesday to $214.88
Thursday. On the New York Stock Exchange, Nortel dipped from an
opening price of $79 on Tuesday to $76.63 Thursday.
The developments highlight the symbiotic relationship between the telecom
carriers, which aim to lay massive networks of transmission pipes to handle
growth in data transmissions over the Internet, and the equipment
manufacturers that supply them.
Now, trends are converging to cause investors to fear that the telecom
spending bonanza is ending. To start with, revenue at established carriers
such as AT&T and WorldCom is growing slower than was expected
earlier in the year, largely because of intense price competition for
consumers' long-distance business.
Meanwhile, some upstart telephone companies are having trouble raising
money to build their networks to compete with AT&T and WorldCom.
And the capital markets have all but shut down for a second group of
upstarts building local networks, the so-called CLECs, or competitive local
exchange networks.
CLEC revenues are growing more slowly than expected, chilling potential
investors. GST Telecommunications, Vancouver, Wash., auctioned off its
assets last month, after filing for Chapter 11 bankruptcy protection earlier
in the year. Many equipment makers have made loans to these upstart
telecom companies, potentially creating problems similar to those Ciena
faced earlier this week.
"If the service operators aren't generating revenue growth beyond single
digits, how long can they continue to rapidly grow their capital
expenditures and infrastructure spending?" says Wojtek Uzedelewicz, a
Bear Stearns analyst who follows the telecom-equipment industry. "The
stock valuations of equipment vendors imply that there will be long-term
sustainable growth."
Indeed, Cisco is trading at about 70 times next year's expected earnings,
or twice its growth rate. Younger equipment makers are valued more
highly. Juniper trades at about 70 times next year's revenue estimates,
while Sycamore trades at roughly 45 times next year's estimated revenue.
Paul Sagawa, an analyst with Sanford C. Bernstein, estimates the two
groups of telecom upstarts will account for 35% of spending on telecom
equipment this year, up from 25% a year ago. But projected spending by
these companies "runs way in excess of the cash being generated by
operations." He adds, "The U.S. [spending] has peaked right now. It does
not grow faster than this."
Some point to the struggling dot-com arena and see other clouds on the
horizon. "It may be more the indigestion in the dot-com area and the
repossessing of existing equipment that will hurt the infrastructure players,"
says Barton Biggs, stock strategist at Morgan Stanley. "I can't imagine that
the demand for routers and equipment will continue to be what it was in the
last couple of years when new businesses aren't being created at the same
rate as they were before."
Skeptics of the spending-decline story say they have heard it all before --
every year around this time, in fact. That is when analysts typically survey
telecom companies about spending plans for the coming year. Trouble is,
the surveys in recent years have often been wrong.
"In each of the last five years, we've gone through the same debate in
August and September," says Douglas Day, who co-manages a technology
mutual fund at American Century Investments. But as the new years
unfolded, the forecasts of mid-single-digit expenditures were "revised up,"
he says.
But some argue this year could be different. "Spending has been growing at
a multiple of revenue growth for the carriers. And what we've seen is that
spending hasn't translated into incremental returns on capital [for the
telecoms]. If anything, the fear is that returns are deteriorating," Morgan
Stanley's Mr. Flannery says.
There is considerable debate about the issue, even inside Morgan Stanley.
Indeed, Mr. Flannery is listed as co-author of a report issued Wednesday
that calls the current fears of a spending slowdown "normal seasonal
concerns" and concludes that spending on equipment "is likely to continue
to be exceptionally strong." The other authors of the report follow
equipment makers for Morgan Stanley.
Another complication for the telecom-equipment stocks is that momentum
investors, who have flocked to them since earlier in the year when shares
of dot-com companies began to fall out of favor, run for the exits at the
first whiff of trouble. So, for instance, comments Thursday to investors
from Qwest Communications International about its plan to increase capital
expenditures next year to $9.5 billion from $9 billion in 2000, may have
sounded good on the surface. But compared with the growth in spending
between 1999 and 2000, it represents a big drop-off.
At 4 p.m. in New York Stock Exchange composite trading Thursday, its
shares were down $2.69 to $48.75.
In other words, a deceleration in growth of any kind scares the wits out of
momentum investors.
Another case in point: Cisco dropped sharply in the days following its fiscal
fourth-quarter earnings announcement Aug. 8, despite reporting a hefty
increase in pro-forma earnings on a staggering 61% increase in revenue. In
part, investors worried that Cisco's growth rate eventually would slow.
Cisco shares have performed worse during the past six months than in any
comparable period since early 1997. At 4 p.m. Thursday in Nasdaq Stock
Market trading, its shares were up $2 to $66.25.
Just how a broader slowdown would hit the equipment manufacturers is
less certain. Brooks Dougherty, who co-manages Scudder's technology
fund, says he believes a slowdown in spending will hit some equipment
suppliers and not others. "People are kind of wigged out about it. We've
taken a look at this and while, on the margin, it's a little riskier than before
this issue came to the foreground, I don't think it's the end of the strong
spending cycle for new-age telecom-equipment vendors."
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