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A Foot in the Door of Wired Homes

By Ari Bensinger To pave the way for dramatic enhancements in bandwidth for Internet service, the nation's three largest Baby Bells -- Verizon (VZ), BellSouth (BLS), and SBC Communications (SBC) -- agreed in May on a set of common technical specifications and standards for fiber delivered to the home. The Bells hope that a potential massive fiber rollout will convince communications-gear makers to drastically lower equipment prices and make it less expensive to install fiber in residences. In June, the service providers began seeking proposals for equipment that's based on these common standards.

The Bells employed a similar alliance strategy in 1995 with the initial deployment of asymmetric digital-subscriber lines (ADSL). Industry experts believe French equipment maker Alcatel (ALA) won that contract due to its aggressive pricing tactics that were rooted in Alcatel's prediction for future large volume deployments. We think the same scenario could play out again -- with vendors pricing their systems below cost to try to win big contracts.

For equipment makers, the stakes are large: The three Bells control approximately 70% of around 190 million access lines in the U.S. The potential size of their fiber investments remains unclear, however, and may depend on the outcome of current regulatory deliberations regarding competitive access to telecom facilities. Nevertheless, with rival cable operators preparing to aggressively roll out voice-over-Internet protocol services (or, VOIP, which allows for voice calls over Net connections rather than the phone company system), we believe that the Bells need fiber connectivity to offer enhanced video services and stay competitive.

FUTURE WINNERS? The equipment makers that we think could potentially benefit from volume deployments of fiber connections are Alcatel, Advanced Fibre (AFCI), and Corning (GLW). We expect Alcatel, a major integrator and supplier of broadband passive-optical networks, to be a primary source of fiber equipment. Its strong position in the digital-subscriber line (DSL) access market is also a significant competitive advantage.

We believe that Advanced Fibre, which already benefits from its interoperability with Verizon's support network, is well-positioned to win a portion of the fiber-to-the-home pie. Given Advanced Fibre's relatively small revenue base of $300 million per year, a sole-source contract with Verizon would significantly improve the Advanced Fibre's financial profile.

Optical cable will likely be a leading indicator of future fiber deployments, as the fiber must be installed in the network before the transport equipment. Given Corning's leading North American optical-fiber cable market share, we see it capturing a significant amount of the available fiber-to-the-home market for optical fiber and cable-related interconnect hardware.

TRIPLE PLAY. Each stock has jumped this year, driven partly by hopes that the outfits will capture fiber contracts from the Bells. Alcatel has shot up 193% so far this year, to $13.04 as of Nov. 12, and Corning has more than tripled, to $11.69. Advanced Fibre has climbed 43%, to $23.87. We at S&P have a 3 STARS, or hold, recommendation on the trio of equipment makers.

For the Bells, fiber to the home offers enormous bandwidth carrying capacity, with estimated data speeds of about 100 megabits per second, vs. roughly 1.5 megabits per second for current standard DSL service. The higher speed will allow phone-service operators the ability to offer triple-play revenue-generating services consisting of voice, high-speed data, and broadcast video.

We believe the Bell at the forefront is Verizon, which plans to deploy about 1 million lines in the first year by building fiber on its existing infrastructure (See BW, 8/4/03, "Verizon's Gutsy Bet"). Most of Verizon's plant is aerial, making this buildout cheaper than for the other carriers.

TRIMMING THE COSTS SBC believes installing fiber in its buried lines is too expensive and plans to do just new construction, or so called "greenfield," builds. Meanwhile, BellSouth has passed 1 million homes with "fiber to the curb" -- which doesn't reach all the way to the home -- mostly on new properties in the Southeast. So far, BellSouth has been quiet about its plans to extend fiber to the home.

Since carriers have to replace antiquated copper with entirely new infrastructure, fiber deployment has proven to be very expensive. Market researcher Vanderslice & Associates believes that installing a typical fiber-optic line in a home has dropped to about $2,000 today, from more than $4,000 five years ago. The firm expects deployment costs will fall an additional 50%, to $1,000, over the next five years.

We believe that carriers will focus initial fiber deployments on more economical greenfield projects. If a telecom is already undergoing initial construction costs to deploy copper, the slightly added cost of installing fiber instead isn't as significant. Moreover, telecom-service providers could use the high-speed fiber connectivity to lure new customers.

FOUR-YEAR PAYBACK. While initially expensive to install, the lack of active components dramatically minimizes network maintenance cost and requirements. We expect fiber to the home to eventually reduce maintenance costs by roughly one-third of the cost of a traditional copper infrastructure. Optical fiber also offers a longer life span than copper and is easy to upgrade for new technologies.

In our view, service operators would need to charge each customer at least $40 per month for new fiber services. Based on an average deployment cost of $2,000, this would require a payback period of approximately four years per customer. We think mass commercial deployment of fiber to the home won't occur until consumers begin demanding applications that exceed DSL's speed limits, such as high-definition TV, online movie rental on demand, remote disk backup, videoconferencing, and interactive gaming.

While we're encouraged by the Bells' fiber-to-the-home request for proposals from gear makers, the timing of actual commercial deployments remains uncertain. After deciding on equipment vendors toward the end of 2003, the Bells will likely commence field trials during the first half of 2004. Assuming the trials don't hit any snags, final deployments would begin in the second half of 2004.

WELL-POSITIONED. Accordingly, equipment makers may not see significant fiber-to-the-home revenue until 2005, at the earliest. We would also note that historically, the Bells have been very sluggish in commercializing new technology. Overall, we think widespread fiber to the home is still years away, and that any potential orders will likely focus on a limited number of new high-end residential communities.

While the time isn't ripe yet, we believe that the communications-gear stocks mentioned above are all well-positioned to benefit when access spending recovers and that telecom providers need to invest heavily in fiber to the home to stave off competition from cable operators. Analyst Bensinger follows telecommunications equipment stocks for Standard & Poor's

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