More Calls for Telecom Gear?
While S&P has a neutral outlook for these battered manufacturers, rising demand for data and voice services bodes well in the long term
The lean times continue for investors in communications-equipment stocks. After lagging the broader market in 2004 -- up 2.3% vs. the S&P 1500 stock index's gain of 10% -- the S&P Communications Equipment index has materially underperformed thus far in 2005 (through Feb. 4), declining 9.4%, vs. a 0.7% dip for the "1500".
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Is there more of the same in store? We at Standard & Poor's Equity Research Services have a neutral outlook for the communications-equipment subindustry. Although we think businesses and service providers will remain cautious in their spending until the U.S. economy shows a more sustainable recovery, we believe the long-term industry fundamentals are strong, with demand for greater bandwidth to support voice, storage, and streaming-video applications leading to network-equipment investment.
In assessing the outlook for communications gear makers, it's important to understand the prospects for its key customers. Below, we share our growth forecasts for the primary end-markets, telecom and enterprise, that drive spending for such equipment.
Telecom carriers
After declining significantly in 2002 and 2003, we estimate that capital expenditures on telecom equipment by U.S. carriers totaled approximately $40 billion in 2004, about equal with 2003, as weak wireline spending offset solid wireless spending growth. Wireline represents approximately 60% of the market, with wireless accounting for the remainder. Service providers are now allocating about 15% of their revenue to capital-spending projects, vs. more than 30% at the spending peak in 2000. We believe a lower, more sustainable ratio of capital spending is essential to creating greater stability in the communications-equipment industry sales cycle.
The current rapid increase in data traffic gives telecom providers the opportunity to create new services, such as high-speed Internet and video access, to offset continued erosion in voice revenues. We regard network-equipment upgrades, which help transport data more efficiently, as the key to creating new applications that restore growth in telecom services.
Service providers have begun to shift their spending priorities toward the last mile, or "edge," of the network by aggressively adding digital subscriber and fiber lines to provide better data access to the consumer. The growth opportunities associated with edge technologies are supported by the aggressive spending plans of several major carriers. Verizon Communications (VZ ; S&P investment rank, 4 STARS, buy; recent price, $36) aimed to install fiber to the premise (FTTP) to one million homes by the end of 2004 and two million by the end of 2005. Project Lightspeed of SBC Communications (SBC ;3 STARS, hold; $24) calls for fiber to the node deployments reaching 18 million homes by 2007, at an approximate cost of more than $4 billion.
URGE TO MERGE. Meanwhile, BellSouth (BLS; 2 STARS, sell; $26) expects to have 80% of its households covered with its new broadband-access network over the next two to three years. Overall, we forecast U.S. carrier spending increasing in the low single digits during 2005.
Currently, the industry's telecom customer base is experiencing a period of heightened consolidation. In the wireless sector, Cingular, a joint venture between SBC and BellSouth, bought AT&T Wireless, while Sprint (FON ; 4 STARS; $23) has announced its acquisition Nextel Communications (NXTL ; 4 STARS; $29).
In the wireline sector, SBC says it will buy AT&T (T ; 3 STARS; $20), and Alltel (ALL ; 5 STARS, strong buy; $52) has agreed to acquire Western Wireless (WWCA ; 3 STARS; $38). And recent press reports indicate that Verizon and Qwest Communications (Q ; 2 STARS; $4) have each expressed interest in bidding for MCI (MCIP ; 3 STARS; $21). Although consolidation should help improve return on capital for service providers, it will likely negatively impact equipment vendors, as a few large players tend to spend less than several smaller companies.
Enterprise customers
We believe that demand for communications gear among enterprise customers depends largely on the strength of the economy. We think recent key economic indicators, such as higher employment payroll growth, point to an improving technology-spending environment. Going forward, enterprise customers will likely make communication-network upgrades a top priority, given the potential productivity benefits and lower operating costs that stem from unified voice and data networks. U.S. spending on enterprise voice- and data-communications equipment totaled $99 billion in 2004, up 5.9% over 2003, according to the Telecommunications Industry Assn. (TIA), an industry trade association. TIA expects the communications-enterprise market to grow to $106 billion in 2005.
We see particularly strong growth in the routing and Ethernet switching market, which is being driven by the convergence of newer applications (such as IP telephony, security, and wireless LAN) with more transitional data applications. Security and quality of service are becoming increasing areas of focus, as enterprises continue to build out their networking capabilities to enhance operational efficiencies.
Overall, we project mid-single-digit industry growth in enterprise networking and telecommunications, the two main markets for communications equipment, as telecom service providers and enterprise customers (large organizations such as corporations, government agencies, and educational institutions) continue to upgrade their communications infrastructure to better handle data and mobile applications.
In both the telecom and enterprise markets, we see next-generation networking gear as a specific area of strength, as traditional circuit-switched networks are being replaced with packet-based systems. In line with this theme, we highlight three of our favorite picks below that we believe are set to benefit from new equipment technologies.
Cisco Systems (CSCO; recent price, $18): The preeminent supplier of routing and switching equipment, Cisco carries S&P's highest recommendation of 5 STARS, or strong buy. We see the company's economies of scale, broad product portfolio, large installed base, and considerable research and development resources as significant competitive advantages. In our view, it is successfully positioning itself in attractive advanced technology markets, such as Internet telephony, home networking, and wireless local area networking. We think its balance sheet is one of the best in the industry, with more than $16 billion in cash and no long-term debt.
Avaya (AV; $13): Avaya carries a 4-STARS, or buy, ranking. Based on its leading market share and largest installed base in the legacy private branch exchange area, we believe that it will be a prime beneficiary from an industry transition towards Internet telephony. We expect earnings to ramp up materially over the next two years, as sales growth begins to benefit from what we expect to be a successful transition to next-generation products.
Polycom (PLCM; $16): We believe that this teleconferencing-equipment maker, also ranked 4 STARS, is well positioned to benefit from increased adoption of voice and videoconferencing as Internet Protocol standards continue to evolve. We view the company's business model as attractive, with gross and operating margins of 65% and 20%, respectively -- some of the best profitability ratios in the industry. |
