'Equipped' for a telecom slowdown
By Jeffry Bartash, CBS.MarketWatch.com
Last Update: 9:25 PM ET Dec 27, 2000
NewsWatch
Latest headlines
Get Alerted
WASHINGTON (CBS.MW) -- After a year of clear sailing in 1999,
telecommunications companies ran into a financial-market typhoon in
2000, with few hints that the storm is set to abate in 2001.
Looking over the horizon, a few companies will ride out the rough
weather, particularly those in the optical equipment sector and the bigger
local phone carriers. For many telecom companies, however, the
turbulence is expected to persist -- and some will likely go under.
For the past year, Wall Street has touted the
equipment makers. The phone carriers need to
upgrade their networks to handle an explosion in
data and Internet traffic, the thinking goes, so it's
best to invest in the industry's "arms dealers." That
approach continues to dominate.
The problem is, the phone carriers have been
engaged in a brutal competitive war. That's slashed
profit margins and shaved revenue growth, stunting
the momentum of the biggest carriers and
threatening the survival of smaller ones. The result:
growth in equipment spending is expected to
decline, at least in percentage terms.
The financial health of equipment makers, in short,
is largely dependent on the health of the carrier
sector. If the carriers shoot each other up too
much, the "arms dealers" won't have as many
customers to whom they can sell "arms."
These concerns, of course, have already rocked
telecom stocks. The phone sector, viewed through
the Standard & Poor's Communications Services
index, has plunged 42 percent since the start of
2000. In a domino effect, that's slashed 56 percent off the Nasdaq
Telecommunications Index, which represents smaller equipment makers.
And while the large equipment makers are better shielded by more
diverse product lines, even that sector has lost as 20 percent of its value
as measured by the American Stock Exchange's Networking Index.
Local woes
The companies most under siege are the so-called competitive local
exchange carriers, or CLECs, the small operators that have sprung up
since 1996 to offer local phone connections and other services. The
sector has already been rocked by several high-profile failures, and
industry executives expect more to fall by the wayside in 2001.
The reasons: Many CLECs are running out of money; they aren't
generating sufficient sales to make up for the shortfall; and skittish
institutional investors are unwilling to provide more loans.
"We're in the third inning of a shake-out in the telecom sector," said Paul
Wright, an analyst at mutual funds giant Loomis Sayles. "The CLECs
don't have cash. The question is, where are they going to get the money?"
That's not to say CLECs should be entirely off limits. Wall Street still likes
the biggest independent local carriers, such as Allegiance Telecom
(ALGX: news, msgs), Time Warner Telecom (TWTC: news, msgs) and
McLeodUSA (MCLD: news, msgs). Those carriers are favored for their
experienced executives, solid cash management, extensive networks and
growing roster of customers. By and large, however, big investors plan to
steer clear.
Talking about "next generation"
Another group facing storm clouds are the "next-generation carriers," such
as Level 3 Communications (LVLT: news, msgs) and Williams
Communications (WCG: news, msgs). For the past couple of years, the
next-gen carriers have been Wall Street darlings. Armed with piles of cash
from venture capitalists, investment banks and stock sales, these
companies spent a bundle on the very latest network technology and have
aggressively sought to pry customers away from the industry giants.
While these companies have scored some successes, their future is by no
means assured. Analysts point out several problems.
For one, most next-gen carriers have been unable to secure enough large
customers to guarantee their success. Quite naturally, the most lucrative
corporations are hesitant to turn their operations over to relative
newcomers who may not be around in a few years. While the AT&T's of
the world still need to upgrade their networks, they do offer proven
reliability -- and a sense of comfort.
"I'll buy from you because my grandfather bought from you," summed up
Rob MacLellan, director of financial advisory services at RHK, a market
researcher that tracks telecom spending.
Another stumbling block could be an emerging glut in network capacity.
While analysts believe individuals and companies will ultimately soak up all
the current capacity and then some, some question whether it will happen
soon enough.
Susan Kalla, an analyst at high-tech investment firm Bluestone Capital,
argues that a glut is developing because of bottlenecks at the local level.
Though customers want high-speed access and the ability to download
big data, voice and video files, they are constrained by limitations on the
part of local wires to handle such information-rich applications.
Even when those local bottlenecks are overcome, she said, network
capacity will quickly become a commodity so cheap it'll be hard for many
carriers to turn a decent profit. "Commodity is a code word for going out
of business," Kalla said.
Big isn't always better
If the CLECs and next-gen carriers run into trouble, it'll probably make
life a bit easier for the big carriers, but not much.
To jump-start sputtering sales, AT&T (T: news, msgs) and Worldcom
(WCOM: news, msgs) have unveiled plans to separate their consumer
long-distance units and focus on Internet- and broadband-related
markets. Yet those carriers, along with Sprint (FON: news, msgs), have
been unable to generate enough sales in new markets to fully offset the
decline in long distance.
That problem is only going to get worse as the resurgent Baby Bells
accelerate their drive into long distance. At the same time, the Bells
maintain a stranglehold on their mainstay local markets and are muscling
into the high-speed Internet business.
"The Baby Bells are in a fantastic position," Kalla said. Telecom analyst
Drake Johnstone of Davenport & Co. agreed. "You have all the Bells
getting into long distance, but the long-distance carriers aren't really taking
any local share."
Still, a few investors are willing to make a small bet on the Big Three in the
wake of a nearly 70 percent decline in the trio over the past year. "AT&T,
Sprint and Worldcom have gotten clocked, but that makes them more
attractive," Wright of Loomis Sayles said. "They're very cheap."
In light of their troubles, long-distance carriers probably would like to
reduce spending, but they can ill afford to fall behind technologically or
neglect nascent markets. Corporate customers are ravenous for speedier
and more sophisticated network services and are willing to pay big bucks
to those that can provide it.
"The carrier executives are damned if they do and damned if they don't,"
MacLellan said.
No optical illusion
That should bode well for the equipment manufacturers. After all, just 10
large carriers, AT&T and Qwest Communications (Q: news, msgs)
among them, account for 80 percent of all optical-equipment purchases in
North America.
Even if a lot of smaller carriers go out of business, analysts say, they don't
buy enough telecom gear to devastate the equipment sector. Some
manufacturers will experience hiccups in sales and profits, but the effects
would likely be fleeting.
Not surprisingly, the biggest change in 2001 won't be on how much
carriers spend, but on where they spend it. Accelerating a trend that took
full bloom last year, phone companies plan to buy more equipment for
optical networks best suited for data and Internet traffic. Optical
networks, which are composed of glass strands and transmit signals via
light waves, are supplanting century-old, circuit-switched copper
networks based on less-efficient electrical impulses.
"They're moving the capital to the new networks, the data-centric
networks, and we're leading that segment," Gary Smith chief operating
officer of Ciena, told CBS.MarketWatch.com. "That's why we are not
seeing some of the slowdowns some of our competitors are."
Picks of the litter
Barring a U.S. economic slump or raging bear market, RHK figures that
carriers will spend roughly $29 billion on optical gear in 2001, up from
$21 billion in 2000 and $13 billion in 1999. That would represent a 36
percent increase, down from growth of 62 percent.
Who would benefit? Certainly the larger, more established vendors such
as Nortel Networks (NT: news, msgs), Cisco Systems (CSCO: news,
msgs) and even the struggling Lucent Technologies (LU: news, msgs).
Those companies offer a broad range of gear to a star-studded list of
clients, many of whom are reluctant to turn to newcomers unless they have
to.
Fortunately for smaller vendors, that is exactly what's happened. Those
with unique or market-leading technology, such as Corvis (CORV: news,
msgs), Juniper Networks (JNPR: news, msgs) and Ciena (CIEN: news,
msgs), have benefited greatly.
"They are making inroads daily with the incumbents. In some cases, they
are the only solution," MacLellan said. "No equipment maker has all the
equipment a carrier needs."
Still, investors can't expect the same outrageous growth rates that
characterized the equipment industry over the past few years. Nor should
they expect the same outsized stock gains, analysts say, unless they latch
onto a rising star on the way up. As for the current industry leaders, their
rich valuations put them mostly out of reach for ordinary stock purchasers.
Whereas last year an investor could pick almost any telecom-equipment
stock out of a cap and reap a big profit, next year investors will have to
put on their own thinking caps. The days of easy profits appear to be
over.
Jeffry Bartash is a reporter for CBS.MarketWatch.com in
Washington. |
