Dial "C" for Caution

Every investor wants to buy cheap. When it comes to the telecom sector, however, it's far from clear that the bottom is in sight

By Sam Jaffe

What if every Iowa farmer had heard the same voice that instructed Kevin Costner to build a baseball diamond in his cornfield? Field of Dreams would have had a much sadder ending. Well, that pretty much has been the story in the telecommunications industry over the past two years. From fairy-tale beginnings, dozens of startup companies built enormous nationwide networks. "Build it, and they will come" was the mantra. Trouble is, nobody came. Today, some 90% of the optical fiber laid on long-haul networks is still waiting for the nonexistent traffic to arrive.

The fallout for telecom-equipment providers has been particularly brutal. Lucent's (LU ) bonds are rated as junk. Nortel Networks (NT ) recently declared a $19 billion quarterly loss. And Cisco Systems (CSCO ) has gone from being the most valuable company in the world in terms of market capitalization to trying to convince investors that its stock is worth more than $20 a share.


  Today, every investor wants to know when telecom capital expenditure will return to its normal growth rate -- when the customers will come, if you will. In 2000, more than $125 billion was spent globally on telecom equipment. This year, that figure is expected to be less than $100 billion. In order for gearmakers to return to health, growth in spending has to bounce back. What will 2002 bring?

The answer to that question will determine the fate of many equipment companies. To find it, you have to put today's telecom industry under a microscope, where you'll find a very different organism from yesterday's.

For one thing, the competitive local exchange carriers (CLECs) -- the upstarts that tried to rival the Baby Bells in providing local phone access -- have all but disappeared. Brand new and bursting with capital just 12 months ago, they had accounted for a major portion of equipment buying. Now almost all of them are gone, leaving the Baby Bells as the only local-access providers.

The Bells have endured competitive threats from the CLECs and the legislative threat from the 1996 Telecom Act, which failed to break up their monopoly power. Given the position of the Baby Bells, what motivation do they have to buy equipment to build their networks? "They are monopolies and monopolies by nature don't need to upgrade anything," says Robertson Stephens analyst Paul Johnson. "They can just sit back and enjoy a guaranteed cash flow."


  That said, Johnson points out there is one thing that will force the Baby Bells to spend money on improvements. As other services such as long distance, wireless, and data get cheaper by the day, price erosion will occur in the local arena as well, thanks to the threat of regulatory changes. The Baby Bells' "pricing power will decline by about 10% a year, and they'll have to make up for that revenue loss in new services. That means upgrading their networks and buying new equipment to do so," says Johnson.

It just won't be the same kind of equipment they bought before, most observers agree. "One thing this shakeout has done is to change the buying habits of service providers," says Atiq Raza, president of Raza Foundries, a venture-capital firm specializing in broadband telecom companies. "Rather than just patching together their old voice-centric networks, which they had to do in the rush of 1999 and 2000, now they're taking the time and money to create all-new state-of-the-art networks."

They're also being much more discriminating. "They have much less money to spend on equipment, and they've become much more thorough about the buying process," says Ciena (CIEN ) Chief Executive Officer Gary Smith. "If you couldn't get funding for a telecom-equipment business plan a year ago, that just means you hadn't printed up your business plan yet. Now we're seeing chief financial officers [of the service providers] involved in equipment buying decisions."


  Such developments appear to be good for companies like Ciena and Sycamore Networks (SCMR ), which make advanced optical products, but not so good for companies like Cisco and Juniper Networks (JNPR ), which make cutting-edge routers for the older networks based on SONET technology. It's especially unsettling news for Lucent, whose product mix is probably the farthest behind on the technology front.

Another telecom front has opened up with the coming of age of the cable modem. "Spending [by cable-TV providers that also offer telephone and Internet access] is up, with the exception of AT&T Broadband, which is stuck in a limbo because of AT&T's (T ) restructuring", says Raza. "The hole left behind by the failure of the CLECs is a huge opportunity for the cable companies, and they're jumping at it."

The other major area of telecom-equipment buying by consumers and service providers -- wireless -- is at a standstill. Wireless "is a train wreck right now," says Michael Marks, the chief executive officer of Flextronics (FLEX ), a contract manufacturer that is the third-largest maker of wireless handsets. "The good news is that handset inventories have dried up, which means we should start seeing orders again in the September quarter."


  That's good news for such companies as Flextronics, Nokia (NOK ), and Motorola (MOT ), as well as handset-component makers RF Micro Devices (RFMD ) and Conexant (CNXT ). It's not so good for Ericsson (ERICY ), which farms out its handset production and relies on profits from base-station equipment, sales of which still aren't going anywhere.

When will spending on telecom equipment recover to its previous 25%-a-year growth rate? The stock answer seems to be 2002 -- but no analyst will give specifics on exactly when spending will resume across the board. That sort of answer usually bespeaks a vague optimism, one without any hard and fast concrete foundation. One feature of bear markets is the general eagerness to call a bottom, even while things continue to get worse. Which is all the more reason for caution, care, and intelligence when investing in this beleaguered sector.

Jaffe writes about the markets for BusinessWeek Online in our daily Street Wise column

Questions or comments? Please visit our Ask Sam Jaffe interactive forum

Edited by Patricia O'Connell

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