Deadweight On The Markets

The telecom equipment makers are in trouble

With tech stocks giving back most of January's surprising gains, the big question on Wall Street is what's next for Nasdaq. Of course, a lot depends on just how much the economy slows. But that's anybody's guess. Better clues can be found analyzing one sector of high tech, the once high-flying equipment makers and their best customers, the telecom carriers. Here the news is not encouraging.

The share prices of equipment makers have depended on growing sales of routers, switches, and lasers to carriers, from upstart local Internet service providers to giant AT&T. Now the spectacular growth in product sales has stopped suddenly, with no recovery in sight this year. The point was made clear in Cisco Systems Inc.'s disappointing earnings and conference call to investors on Feb. 6.

Equipment stocks, representing what had been the most dynamic sector of the economy, make up fully one-fifth of the value of the Nasdaq 100. They are led by Cisco, which last year passed Microsoft Corp. and General Electric Co. briefly to hold the title of the stock with the biggest market value in the world. Though Cisco's $220 billion market cap is down 60% from its 52-week high, it is still the eighth-biggest in Standard & Poor's 500-stock index.

PRICE WARS. The big Nasdaq issues also include flashy optical innovators JDS Uniphase, CIENA, and Juniper Networks. They are followed by a raft of suppliers, such as semiconductor makers Applied Micro Circuits, Altera, and PMC-Sierra, a darling of momentum investors. Other equipment names are prominent New York Stock Exchange technology listings, such as Nortel Networks Corp. and Corning Inc.

The trouble in the equipment ranks is likely to get worse. The problem is twofold. First, their stock prices are still generally high compared with earnings. Investors have hesitated to sell them because they had become the leading growth stocks. Second, problems with the telecom customers won't go away quickly. The telecoms have run up big debts buying and installing the latest high-tech equipment. They're using that new capacity to wage deadly price wars with one another and won't have the money to boost spending.

Telecoms increased their purchases of equipment by nearly 30% in 2000. In doing so, their capital expenditures exceeded their cash flow by 50%, estimates Paul Sagawa, equipment stock analyst at Sanford C. Bernstein & Co. (chart). This cash shortfall amounted to $50 billion, most of which had to be raised from the capital markets, with some coming from the equipment companies themselves. Total carrier debt is now 91% of sales, compared with 29% four years ago.

Many of the communication equipment stocks remained stubbornly high despite indications spending would stall. Cisco, moments before its earnings disappointment, was trading at a lofty 41 times Wall Street's estimates of calendar 2001 "pro forma" earnings, as tallied by First Call/Thomson Financial. If instead of "pro-forma" earnings analysts focused on actual earnings, which reflect some expenses for stock compensation and acquisitions, the p-e would be even higher. After Cisco's gloomy news, its stock fell 15% as analysts slashed earnings estimates. JDS Uniphase Corp. is down 65% from its high but still commands a 50 p-e. Juniper Networks Inc. and Sycamore Networks Inc. are near 100.

"WISHFUL THINKING." Portfolio managers began taking notice of the threats to equipment sales in September, a key reason those stocks in the S&P 500 fell 48% the last four months of 2000. Thomas M. Galvin, U.S. stock strategist at Credit Suisse First Boston, recently recommended the stocks as bargains, saying the Federal Reserve rate cuts are encouraging capital markets to resume financing of carrier spending.

But that may be too optimistic. "There is wishful thinking that has been brought about by the experience of the last four years and this boom-boom environment," says Sagawa of Bernstein. In September, he made a prediction, based on a survey of carriers and their financial positions, that equipment spending growth would fall from nearly 30% in 2000 to less than 20% in 2001. Then equipment executives said orders were strong and the threat of a slowdown overblown. Now, they carry inventories that swelled when business did not materialize. Sagawa says the outlook has grown worse and equipment spending will grow no more than 10%, if that.

Raising money just to maintain current spending won't be easy, because lenders see price wars eroding the carriers' cash flow margins. Prices for long-distance data transport have been falling 20% to 50% annually, according to carrier Level 3 Communications Inc.--and even bigger price drops are coming. Level 3 Chief Executive James Q. Crowe says capacity-enhancing advances in fiber optics will allow him to slash prices 60% to 80% every year in his quest to take market share and build traffic. The price drops can be so dramatic because technical advances allow carriers to double the amount of data they ship every nine months for the same cost--a pace of improvement twice that of advances in computer processing, says Crowe. He calls his tactic "disruptive pricing," adding: "Somebody's going to do it, so it might as well be us."

That should send a chill through the equipment companies. Before his price-slashing generates significant new demand, Crowe will spill more blood among his fellow carriers--and among investors who bet equipment stocks won't go lower.

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