Tougher Calls for Wireless Gearmakers
MARCH 25, 2005
Advice from Standard and Poors
TECH KNOWLEDGE • From S&P
By Kenneth M. Leon
S&P is neutral on the group, thanks to major consolidation among service provider customers. Qualcomm, however, should hold up well
At Standard & Poor's, Our investment viewpoint for the wireless telecommunications equipment group is neutral. That's because of the weak demand we see in the first half of 2005 due to spending delays from national wireless providers involved in mergers and acquisitions. Since January, 2003, our composite telecom wireless equipment index was up 22%, strongly outperforming the S&P 1500 index. Year-to-date through Mar. 21, the wireless equipment group declined 10%, vs. flat performance for the S&P 1500.
With the quick consolidation of service providers around the world, we believe equipment suppliers may be exposed to less predictable capital spending patterns from wireless carriers. The gearmakers are also under greater pressure to attain the role as a strategic supplier to the dominant carriers and expand those relationships with professional and network services. In addition, we expect delays in deploying third-generation wireless technologies and in finding cost-effective channels for distributing wireless network products.
NARROWED OPPORTUNITIES. In a rapidly changing industry, service providers are demanding proprietary software applications for planned service features. We believe suppliers that have a strategic role can plan according to the demand of a large but difficult customer, whereas a supplier that has a weak relationship with the same carrier may not have the direct insight or the opportunity to win the business.
In our opinion, as the number of key customers for wireless equipment has become smaller due to consolidation of service providers, the opportunities to win a new contract have narrowed. In the last few years, we believe vendor-customer relationships have become much deeper with shared efforts to streamline, enhance, and upgrade a major carrier's network. In many situations, the lead wireless gear vendor may have its employees located at the carrier's network operations and control centers.
For handset makers, the good news is unit shipments should be fairly strong. We forecast global handset shipments growing 8% to 10% in 2005, vs. 33% in 2004, as market conditions remain stable for the handset replacement market in developed countries and as emerging markets contribute to strong growth from China, India, Southeast Asia, Latin America, Eastern Europe, and Russia. We believe key drivers in developed countries should be the replacement handset cycle for third-generation (3G) handsets based on technologies such as CDMA 1xEV-DO and WCDMA, as the leading wireless carriers upgrade their wireless networks.
LATE SPENDING SURGE? However, growth in the wireless infrastructure market is slowing because of delays in capital spending plans. Globally, this market reached $22.7 billion in 2004, a 31% increase from 2003, according to researcher Dell'Oro Group, as service providers expanded cell coverage, upgraded base stations, and began to migrate to 3G network platforms. In 2005, we forecast flat to 5% growth in global wireless capital spending. We believe the money may not be evenly spent throughout the year, with a late-2005 surge possible, especially for 3G network upgrades.
As the industry moves to 3G technologies such as WCDMA and CDMA 1xEV-DO, we believe suppliers' margins should narrow as initial system bids are normally below established network platform margins. While many competitive factors go into a wireless carrier's decision, we believe that price will be key, in addition to product features, quality, general availability, and the relationship with the customer. Another deciding factor is company image, which may hurt Nortel Networks (NT ; ranked hold; recent price: $3) given its accounting investigation, in our opinion.
Though we're neutral on the wireless equipment group as a whole, we do like a few stocks. Our favorite is Qualcomm (QCOM ; ranked strong buy; $36). Despite weaker sales expected in the second fiscal quarter vs. the first quarter, Qualcomm is confident it can reach its fiscal-year 2005 (ending September) sales target of $5.8 billion to $6.3 billion, with earnings of $1.16 to $1.20 per share. We believe the company, unlike its peers, has pricing power with its intellectual property and patents for the CDMA standard.
VERY ATTRACTIVE. We see Qualcomm's addressable market for license fees and chipset sales growing from 24% of the global handset market in 2003 to 45% by 2008. We believe the key drivers will be replacements in Europe and the U.S., and rising demand for CDMA handsets in China, India, Japan and South Korea.
We view Qualcomm as having a very attractive financial model, with wide gross and net margins, no long-term debt, and $8 billion in cash at the end of its fiscal first quarter of 2005. Applying discounted cash-flow analysis and a price-earnings multiple of 36.6 to our fiscal year 2006 EPS estimate -- a premium to peers that we think is warranted by what we view as above-average growth potential -- we arrive at our 12-month target price of $53.
Risks to our opinion and target price include the possibility that developed countries won't keep pace with the high replacement rate expected for more advanced CDMA handsets, slower-than-expected wireless subscriber growth in emerging countries such as China and India, and potentially weaker-than-expected CDMA handset shipments.
Besides Qualcomm, we have one strong buy -- Powerwave Technologies (PWAV ; $8) -- and two buy-recommended stocks, Motorola (MOT ; $15) and Nokia (NOK ; $16), in the wireless equipment group. Stocks ranked hold include Lucent Technologies (LU ; $3), LM Ericsson (ERICY ; $28), Nortel, and Alcatel (ALA ; $13). We have a strong sell recommendation on Siemens (SI ; $79), as we see its competitive position weakening.
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