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The "Triple Play" in Communications Gear

The shares of communications-equipment makers have been stuck in low gear for the last few years, hampered mostly by customers' reduced spending and consolidation of telecom- and cable-services providers. The move by these operators to offer voice, data, and video -- a so-called triple play -- as well as the ability to have those services move across fixed and mobile networks, could finally translate into better times for equipment suppliers. "We believe the industry is coming into a new dynamic," predicts Ken Leon, who follows the group for Standard & Poor's Equity Research.

In 2005, through Oct. 31, the S&P Communications Equipment index is faring a bit better than many other tech industries, and is down 1.1%, vs. a 0.4% drop for the S&P 500 index. In the last five years, the equipment index plunged an average of 24.4%, vs. a 3.3% decline for the broader market.

Leon's favorite stocks in the group are Motorola (MOT) and Scientific Atlanta (SFA), each ranked strong buy. These companies should benefit from strong spending on broadband gear by cable operators, he says.

Karyn McCormack of BusinessWeek Online spoke with Leon on Nov. 1 about the latest trends and his favorite stocks in the group. Here are edited excerpts of their conversation.

Note: Ken Leon is a Standard & Poor's Equity Research analyst. He has no ownership interest in or affiliation with any of the companies on which he writes research. All of the views expressed here accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this chat.

Communications equipment stocks have been in the doldrums for a while. Do you see a recovery on the horizon?

The lackluster performance has come from investor worries about the future growth rate of the equipment market, capital-spending trends, and potentially, the accelerated consolidation of service providers that may lead to pricing pressure on the vendors. This has put pressure on the group for most of 2005.

We believe the industry is coming into a new dynamic. It's offering communications equipment to what were viewed to be separate markets -- the enterprise telecom service providers and the cable-TV market. We're beginning to see new products offered for convergence.

Is this the big trend in the industry? How will equipment makers benefit?

Everyone thinks the big trend is "triple play" -- which is the ability of a service provider, both cable and telecom, to offer voice, data, and video, all on one platform. We think this will be taken to an even bigger level, which is the convergence of wireless with broadband fixed line networks (see BW Online, 10/21/05, "Wireless Goes Boom").

The industry has been developing a standard for this the last few years called IMS - which is Internet Multimedia Subsystem standard -- which has allowed the vendors to in the last year or so to develop products capable of offering services seamlessly to a user who moves between a mobile network and a fixed network for all their services. We think that's very powerful.

We've seen recently company announcements that suggest that there is viability of this in the marketplace, both from the standpoint of major orders and also some major acquisitions by the equipment companies so that they can offer IMS across mobile and fixed lines.

Can you give some examples of mergers or partnerships?

The global equipment vendors need to be able to offer wireless and fixed line capability (see BW, 10/24/05, "Less Dashing To Find The Cell Phone"). Ericsson (ERICY

; ranked hold) announced last week plans to acquire the fixed line business from Marconi for $2.1 billion. This move was made to round out Ericsson's portfolio, which was pretty much wireless.

There are only a handful of major suppliers that are deep in offerings for both sides of the network -- and that would be Motorola (MOT

; ranked strong buy), Lucent (LU

; ranked hold), Nortel (NT

; ranked sell), and perhaps Alcatel (ALA

; ranked hold). Nokia (NOK

; ranked hold) does not have a fixed line capability for broadband, and this may create a vulnerability for Nokia, in our view, compared to those that do offer IMS.

Which companies are best positioned?

The best formula is an equipment vendor that has a market leadership with key addressable markets and also has a capability of offering equipment across both fixed line and mobile. We think Motorola has that profile. It's the No. 1 vendor for the cable television equipment market. They're a market leader in wireless infrastructure and wireless devices.

Motorola also strategically has an advantage over Lucent, Nortel, or Alcatel in that it doesn't have the challenges of moving away from the legacy fixed line customer base that they have of circuit switches and things like that. Motorola has made some acquisitions and today has a fairly robust IP-based fixed communications offering. So the combination of customers and not having the difficulty of moving from legacy to next-generation IP gives Motorola, we think, an advantage.

In general, what's the strategy of equipment suppliers? Are they still highly reliant on telecom operators' spending budgets?

The telecom operator and cable television markets are very consolidated. If you look at any region of the world, there are three to five service providers that command more than 75% of capital spending in each region. So there's been enormous uptake in the pricing power of the buyer, and this has put pressure on the equipment vendors to not only offer best-in-class capability, but also offer other things to get value-added pricing. This means professional services to install or manage those networks, and also giving support services to these large carriers.

So what's setting them apart?

In broadband, it's the rapid move to an IP-based platform for voice, data, and video. There are some vendors that are stronger in access such as Alcatel for broadband, and others that are stronger in transport and switching and the core of the network such as Lucent and Nortel. All of this is coming together.

You certainly don't want to be in fiber optic long haul because that market is pretty much tapped out. But this whole movement of these triple play services on a broadband IP-based network is the key. And at the same time, making it seamless to move to the mobile network. That's what's happening in 2006. It's beginning to happen in 2005, but I think anyone who can't go to the table offering a full IMS platform is going to lose market share.

Besides Motorola, you also like Scientific Atlanta how come?

Scientific Atlanta (SFA

; ranked strong buy) is also a leading equipment vendor for the cable market. Unlike the telecom service provider market for equipment, cable has been almost a duopoly enjoyed by Motorola and Scientific Atlanta. We see strong spending for this IP convergence from cable operators as much as we see it from telecom carriers.

In our view, that makes Scientific Atlanta very attractive. They do have a strong capability of offering subscriber set-tops to network infrastructure for cable operators. There have been some media articles suggesting that Scientific Atlanta might be attractive as an acquisition target by some of the other large equipment vendors that are not really in the cable market but they're in the telecom equipment market. We certainly think it's well-positioned and those relationships with major operators are very valuable.

We can't comment on whether it is or isn't an acquisition target, but strategically, Scientific Atlanta and Motorola are uniquely positioned in the cable market that might be viewed attractive by the other major equipment suppliers that are only in telecom or enterprise markets.

So investors should look for gear makers that are taking advantage of both wireless and "triple play," but also have a foothold in the cable area.

You have to. If we look at what was in for 2005 might be out for 2006 -- which was this whole migration path from second-generation to third-generation wireless, or 3G.

Some of the leading service providers in developed countries like the U.S. -- Verizon Wireless and Sprint -- will be fairly complete with that program in 2006. So if you're only offering a wireless infrastructure and not IMS for convergence, then you're going to lose out.

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