Robert, I am curious as to what you are talking about. you have yet to say anything except that you saw a clip on CNN about the decline in network sales. Please explain to me and everyone on the thread how that represents the truth in regards to NT or the rest of the sector.
this is an interesting post from another thread...
Message 14372618
then there is this opinion...I hope that you can keep up with the part where this cycle has occurred more than once in the past...
ssb 9/21/00
Sentiment Belies LT Industry Growth;Strongly Reiterate Bullish Stance
Sentiment Belies LT Industry Growth;Strongly Reiterate Bullish StanceMcLeodusa Inc(MCLD)#* Rating: 1S As of 09/21/2000 Last Changed 11/30/1997 Salomon Smith Barney ~ September 20, 2000 Telecommunications Services Sentiment Belies LT Industry Growth;Strongly Reiterate Bullish StanceSeptember 20, 2000 SUMMARY * Given the meltdown in the group, we are reiterating our bullish stance on the sector with our long-term investment thesis and favorite stocks remaining unchanged. * We believe Wall Street is allowing the depression in the telecom stocks to dictate research. Telecom remains a capital intensive growth industry and many negative issues that others are pointing to are not However, as we saw with MCI which lost at least 50% of its value on 9 different occasions before being bought by WCOM, stocks rarely go straight up. * Technology & public policy changes have caused disruptions in the industry but we believe are positive for the industry long-term and create huge growth opportunities. We continue to believe that lower costs will drive demand for higher-bandwidth services and the notion of a bandwidth glut is preposterous. OPINION We want to take this opportunity to strongly reiterate our bullish view of the telecom services industry. We remind people that our long-term investment thesis on this industry remains unchanged despite the fact that the stock performance of the telecom services sector has fallen off a cliff. First, we believe that the revenue growth in this industry over the course of the next 5 years will actually accelerate as we shift the mix of revenue away from circuit-switched voice towards packet-switched services, optically-based services, and especially bandwidth-intensive services. Second, we believe that as capital spending goes from roughly 30% of revenue to probably 15%-20% of revenues, over the course of the next 4 or 5 years. We believe we will start to see free cash flow generation and accelerating return on invested capital as the new capital deployed in the current environment drives down operating cost and enables a slew of new applications. Third, we have always believed in the segmentation of this industry. This is a $1 trillion industry on a global basis, almost a $300 billion industry in the United States - with very different sets of telecom service buyers,ranging from consumers to SMEs to large multinationals to technology buyers that simply buy bandwidth. Thus, there is opportunity for multiple business plans to succeed. This is not an old vs. new, horizontal vs. vertical debate. Rather, the skilled management teams in every segment of this industry should be able to drive value. The basic tenets of this industry has remained unchanged in the 25 years that we have been associated with telecom. Technology drives down costs, which drives down prices, which stimulates demand for existing services. Secondly,Say's Economic Law has always been valid. Namely, expansion of supply creates its own demand. Thus, new applications are enabled with the prevalence of cheaper bandwidth. The most value is driven in any element of the value chain by companies that have the most pervasive set of network assets off of which to drive the fullest product set and hence capture the most customers. The telecommunications services sector has typically outgrown GDP by a factor of 2 to 1 over the last 3 decades. We would argue that this multiplier willincrease as network-based services become the enabler for what is a web-centric world.
STOCK PERFORMANCE HAS BEEN LACKLUSTER
Having said all of this, why is it that the stock performance of this group - top to bottom - has been miserable? With ytd performance of this group anywhere from down 25% to down 60% across the board, with 52-week performance not much better. Specifically, the incumbent players are trading at their lowest relative P/E's in 5 years. In fact, they have lost 3 to 4 relative multiple points to the market in the last 26 months. The emerging players are trading near their lows. They are near their historic, albeit short (since many came public over the last 3-4 years), lows on forward multiples on revenue and netplant and clearly are trading at very steep discounts to DCF values, even if one wanted to haircut DCF values going forward. The reason we believe that the sector is under pressure and continues to be under pressure is that we believe that other analysts are raising issues that are not new - other than the fact that the stocks are down a lot. We thought we would take this opportunity to address some of what we believe is overhanging the sector. We particularly wanted to provide our commentary on these issues. Before we do that, we thought it would be appropriate to remind people that from the time MCI Communications went public, in 1972, to the time it was bought by WCOM, in 1998, MCI outperformed the S&P 500 by 8 to 1 with a cumulative price performance of 6000% vs. 800% for the S&P 500. MCI outperformed the NASD by 4.5 to 1, with a cumulative price performance of 6000% vs. 1300% for the NASD. During that time, MCI lost at least 50% of its value on 9 different occasions. In particular, if you look at the period from October 1973 to October 1989 - the last time MCI had such a downdraft - MCI outperformed the S&P 500 by 10 to1, and the NASD by 7 to 1. This was in a 16 year period, despite losing anywhere from 52% to 84% of its value peak to trough, 9 separate times. Our point is the following: Telecommunications is, and remains, a growth industry. Telecommunications is and remains a capital-intensive industry. Thus, companies in this industry will always go through spending periods to develop network infrastructure, which drives products, which drive growth. Because of the nature of the beast, there are hiccups along the way. MCI remained, clearly, Exhibit A in both the travails and - more importantly - the benefits of being a well-run company. It started from nothing and gained critical mass in a growing, but capital-intensive, industry. Thus,. we thought we would walk through a few points to hopefully put investors at ease in terms of this group.
TECHNOLOGY & PUBLIC POLICY WILL CREATE GROWTH OPPORTUNITIES
First, there are 2 cataclysmic changes going on: technology and public policy. Five years ago, less than 5% of the 700 million U.S. phone lines were in markets with open competition. Today, over 90% are. Secondly, we are going from a circuit-switched world to an optical packet-switched world. Ultimately, everything will be characterized by bits per second (bps), as opposed to minutes or circuits. Either of these changes would be disruptive. Both, simultaneously, are clearly disruptive. But, at the end of the day,the result of public policy opening up markets and the shift to optical,packet-based bit-driven technology - the combination of these 2 things - will dramatically expand the market for telecom services. Obviously, the challenges for all players in this industry is to navigate through these changes. Open competition provides huge opportunity for new players that have to build businesses and it provides challenges for incumbent players to diversify assets to grow through what will be inevitable share loss. The technological shift, we would argue, is a more subtle change. There is no question that revenue per binary digit, for voice services, will come down as we go to an all-packet world. However, cost also comes down. With the demand for bits going through the roof, the long term ramification of a bps-based telecom world is quite beneficial. There will be a transition period as legacy revenue streams will reflect the pricing of lower-cost networks. Thus, we would argue that technology and public policy changes are for the good of this industry, will create huge growth opportunities, but have to be navigated through over the course of the next couple of years.
CUSTOMERS & BREADTH OF SERVICES ARE CRITICAL FOR GROWTH
The name of the game is simple: to have the most customers and the most services no matter what type of company you are. A company can be vertically-integrated, horizontally-focused, SME-oriented, or a multi-national corporate supplier. That, obviously, leads to different challenges for old vs. new companies. New companies have the luxury of starting from scratch, taking market share and being able to have entirely new networks built. However, they have to be able to build a business, not just assets. They have to finance their business plans. They have to build infrastructure in order to compete. On the other hand, incumbent players do not really have issues with capital. They have a lot of customers and revenues, but are faced with loss of marketshare and devaluation of legacy revenues. Thus, the incumbents have todiversify assets and create new services to drive growth. We would argue that the better new companies and the better old companies, the better vertically-integrated companies and the better horizontally-focused companies, will all - at the end of the day - drive value. It is not a zero-sum or a mutually-exclusive gain. Thus, as we said, issues that have been raised regarding oversupply of bandwidth, CLEC business models being viable and financeable, return on capital are nothing new. In fact, the issues could have been raised a year ago, when the stocks were 60% higher.
COST EFFECTIVE NETWORKS HELP DRIVE DEMAND & WEALTH CREATION
Let's quickly look at each of these issues. As far as bandwidth isconcerned, we have talked about this a million times. We will continue to stress the same thing. The cost-effectiveness of optical networks for new applications is a means to wealth creation in this industry. We've heard all the chatter: five new networks crisscrossing the continent, a flood of new fiber, excessive Pan European networks, a bandwidth glut to last until the middle of the next decade. We emphatically beg to differ. Number 1, fiber in the ground does not equal bandwidth in the network. Fiber does not equal bandwidth because the incremental cost of installing as much fiber as possible while digging up the earth is cents per fiber meter. Therefore, while you are digging up the earth, you might as well put in as much fiber as possible in the first installation. However, fiber in the ground does not stay useful forever because it could be in the wrong place. Fiber does age and get damaged over time. You may have the wrong specs and not be able to pass high-speed signals. Furthermore, operators tend to run their networks in a very disciplined way. A company will not light up a fiber pair until there is visibility of 35%-40% of utilization on that fiber pair. If a company runs a fiber pair much above 60%-65% utilization, or it will not be able to guarantee the network integrity needed for optical carrier and high-bandwidth services. Moreover, on terrestrial networks, the cost of lighting up fiber is roughly 8x what it costs to build a network. That's only assuming 1/3 of the dark fiber is ever lit. In fact, most network engineers would argue that no more than 20% of dark fiber will ever be lit. Thus, fiber in the ground is interesting but irrelevant. Bandwidth has everything to do with what is lit, which is directly demand-driven and demand is growing. Furthermore, bandwidth required is growing faster than traffic; thus; optical networks are going to be hard-pressed to keep up with demand. If you do the math, it's quite simple. There are more users using faster devices at the edge of the network with more applications - whether it is streaming content, real-time software downloading, caching, and the like. These services are driving more time on-line, more bandwidth per device, and higher payloads per unit of capacity. Most forecasts for growth of just IP alone create the prospect of a network with 30x today's traffic on the public-switched network in less than four years. In fact, according to industry sources, total demand worldwide for data and voice will grow from roughly 4 billion Gbps per year to almost 20 billion Gbps per year by 2005. Additionally, in a packet network, packet traffic is engineered very differently than voice. In a voice world, a network is engineered for predictable peak hour usage. In the packet world, the network requires huge excess bandwidth to function properly with bandwidth supporting peak traffic loads. Bandwidth is needed to support retransmission, recovery and unpredictable bursts of data. When one makes a voice call and that circuit goes dead, the calling party hangs up and calls back. In contrast, when a network provider is guaranteeing no packet loss on data transmission, if there is one lost packet, it requires the retransmission of the entire payload - not just the lost packet. The faster the transmission, i.e. the faster the speed guaranteed, the more data that is in the glass that has to then get re-transmitted. The solution is more bandwidth. The restoration and recovery requires re-transmission of more than just the lost information but the restoration and recovery cascades throughout the network, bringing down other routers and other devices. There is a very simple solution: the network engineer throws more bandwidth in the network to overprovision. Furthermore, forward error correction is required to transmit extra data. The bottom line is that as bandwidth demand increases, bandwidth required increases more. There is no question that price per bit will decline due to traffic mix. Clearly, voice on a per bit basis is priced much higher than data and packet-based services. But, data bps are going to grow by a factor of 10x while voice bps are only going to grow at 50%. Thus, the bottom line on the bandwidth side is that as costs for putting in technology in a network decline, which they have from $210,000 per Gbp in 1994 to $4,000 per Gbp today, bandwidth becomes more prevalent. The decline in cost drives more bandwidth demand and it is also important to note that dark fiber does not equal capacity. As the bps that require more network protection and restoration grow at many multiples of the bps that don't require such protection: it becomes a self-perpetuating thing. The more applications that use more bandwidth that require more sophisticated protection and restoration means even more bandwidth is required to serve the end-user. Thus, we believe that the notion of bandwidth glut is preposterous. We have heard this refrain over the last two decades, and the reality is that as cost per unit goes down, drives down prices, drives up demand, but the reality of network engineering is that the more bandwidth demand that is required, the more bandwidth supply is required to meet that demand within the specifications promised. One important issue to the industry is that as we speak, 60% of the bps are voice, whereas in 5 years, 80% of the bps will be data. Obviously, this has ramifications on revenue per bit. However, cost per bit is declining even faster.
WE BELIEVE THE CLEC MODEL REMAINS A VIABLE BUSINESS PLAN
The other issue that is worth addressing is the viability of the CLEC model. The bottom line is that there are clearly too many companies out there, as opposed to too much capital. As we have seen in the banking industry, we do believe there will more consolidation and fewer companies within the emerging network area - just like we have seen within the incumbent space. In the meantime, the basic premise of the CLEC model is unchanged. The fact is that 15% of the RBOC assets cover 70% of the RBOC business lines. Thus, a CLEC can cover 50%-60% of RBOC cash flow by overbuilding roughly 15% of RBOC/ILEC assets. It is clear that as the CLECs are adding a half a point to a point per quarter of market share - representing 60%-70% of the growth in net adds - that the CLEC business model is working. There are obviously issues with transitory revenue streams such as recip comp and switched access. The reality is that the better names in this space, we believe, will build viable business models. We would argue that in the course of the next 5-10 years, the CLECs as a group could clearly capture 30%-40% share of the local exchange business market if one could even define a market that way in the out years. As far as financing is concerned, the better names - MCLD, NXLK, ALGX, WCII, FCOM - should be able to fund their businesses and build viable business plans. In fact, the MCLD bonds are outperforming the high yield market significantly and still trading at about a 10% coupon. Most of our CLEC names are only trading a couple hundred basis points wider than the Bells and almost at par.
RETURN ON CAPITAL INVESTED CALCULATIONS REQUIRE A MULTI-YEAR VIEW
As far as the final issue, return on capital, that is making the rounds these days. We find it interesting that people have resorted to a 1-year outlook of incremental revenue relative to incremental capital. That, in a word, is preposterous. If that analysis was used, we would still be talking on rotary phones on microwave networks. Never, in our 25 years of experience, has a major technological changes seen a payback much less than 3 years. However, on a moving 5-year average, this industry has typically earned a return on invested capital of roughly 1.5x - 2x its cost of capital. In the 1980s, when the Bells went from analog to digital switches, it was not done to simply offer local dial tone. Rather, it was done to be able to provide services like caller id, call waiting, voicemail that did come to pass several years down the road. When the long-haul networks went from microwave to digital radio and then from digital radio to the first fiber networks in the late 1980s and early 1990s, that clearly was not done to offer voice long distance. The point is that the capital deployed in this industry supports revenue streams over a 5-10 year period of new services. Thus, when you look at the return on capital for this industry, you have to make a leap of faith on new applications, but our experience shows that new technology always results in new applications and new services. Thus, we would argue that over the course of the next 5 years, as the declining cost of technology coupled with the wealth of applications enabled by the technology kicks in, the ROIC in this industry five years from now is actually going to be a lot higher than it is today.
THERE IS A DISCONNECT BETWEEN THE EQUIPMENT VALUATIONS AND SERVICES VALUATIONS
This leads us to one last point. There is clearly a disconnect between the valuations of the equipment companies and the valuations of the service companies. In 1996, if one looked at the totality of market cap between service and equipment, the equipment companies accounted for roughly 20% of the total market cap. Today, the equipment companies account for 60%-70% of the total market cap. More specifically, if the revenue forecast embedded in the equipment companies to support current valuations are correct, then unless one thinks the network service companies are completely moronic and will keep spending money even if the returns are sub-par (which is clearly not the case), then obviously the growth rate in network services is clearly quite superior relative to what is being implied in the current stock prices of the network service companies. There are a couple of scenarios. The network service companies know what they are doing and the demand will be there; there will be rationalization in terms of industry consolidation - which we believe - and thus, returns on capital will be reasonably above cost of capital and thus the stocks are dirt cheap here. If that is not true, and the service companies are fairly valued here - which we don't believe, then look out below on the equipment side. Our view is that the investment in network technology will continue to be robust, especially towards the edge of the network and in metro areas, as well as going beyond the transport layers of the backbone. With cost of technology 40%-50% per annum, and enabling new applications, we believe network spending, while not running at a 35%-40% rate as it did in 2000, will nonetheless continue to grow at roughly a 10% rate give or take each year. With that, the network service companies in total can see free cash flow out a few years and increasing returns on capital as the paybacks on this technology kicks in. That scenario dovetails with the current valuations of the optical and equipment stocks. Our view is that the equipment stocks are not overvalued, but rather the network service stocks are woefully undervalued relative to the long term opportunity.
WE REITERATE OUR FAVORITE NAMES
As far as the names are concerned, everybody knows what our favorite names are. But our view is that current valuations with the incumbent players trading at very low relative P/Es and the emerging players clearly trading at the low end of their historic ranges on forward revenue or net plant multiples - just like this industry went down in unison. We would argue that in the next 12 months, a market-weighted index of the telecom service industry will be significantly higher than it is today across the board. Our view is that among the incumbent players, WorldCom# (WCOM/$28.44/1M), Qwest (Q/$47.00/1M), Verizon (VZ/$43.56/1M) and SBC# (SBC/$45.50/1M) represent the best combination of value assets and accelerating growth potential. Regarding WCOM, we continue to believe that WCOM has the best set of assets in this industry and we strongly reiterate our Buy rating. Qwest has the highest visibility on near-term numbers given its synergies with US WEST. VZ and SBC are trading at historically cheap levels and have incremental growth opportunities coming from DSL and long distance entry. Given our view of bandwidth, we want to be very overweight the bandwidth names. Global Crossing# (GBLX/$30.02/1S), TyCom# (TCM/$38.75/1S), Metromedia Fiber Network# (MFNX/$27.81/1S), and Flag Telecom# (FTHL/$10.94/1H) clearly represent bottleneck assets. Level 3# (LVLT/$74.00/1S), Williams# (WCG/$22.88/1S) and Broadwing (BRW/$25.19/1M) clearly represent leveraged plays on bandwidth. Among the CLECs, no surprise, continue to be McLeodUSA (MCLD/$12.06/1S), NEXTLINK# (NXLK/$27.00/1S), Allegiance# (ALGX/$40/1S), Winstar# (WCII/$19.44/1S) and Focal# (FCOM/$21.75/1S) - all of which have good visibility on current quarters we believe. These business plans are superbly managed and will have no trouble accessing capital. NET/NET We believe Wall Street is allowing the depression in the stock prices to dictate research. Issues that are being raised are not new and could have been raised when these stocks were 70% higher. We fundamentally believe in the growth of this industry, in the potential for value creation in this industry. But it ain't easy. Anyone who thought that this group would just go straight up was sadly mistaken. At a time like this, when the valuations are absurdly low, and there is huge capitulation on Wall Street, we thought it was a good idea to remind people where we stand. We are very aggressive on these names. Clearly, on any subset of the names we alluded to, we would be buying aggressively. |
