Light at the End of the Fiber?

Finally, the telecom depression is starting to lift

On the surface, telecom still looks like a mess. News about the industry is dominated by WorldCom Inc.'s bankruptcy and the scandal surrounding Citigroup's (C ) fallen telecom guru, Jack Grubman. Local phone giant SBC Communications Inc. (SBC ) is in the midst of laying off 11,000 people, while its executives warn that new rules forcing it to sell local phone service to rivals could bankrupt the company. All the while, telecom players are groaning under too much debt and too much capacity.

Dig deeper, though, and you'll see signs that the two-year-old depression is actually beginning to lift. Trends point to a turnaround that, experts say, could arrive sooner than the 2004 many had been predicting. The new cyclical nature of telecom, which tracks the economy more closely, could lead to increased spending in the coming year. Prices have stopped falling in key markets. Potentially lucrative broadband is catching on just as dazzling new phones hit store shelves. And there has been a smattering of good financial news. "The fourth quarter could mark the bottom of the telecom depression," says Tom Lauria, founder of consulting firm Avtera Management LLC. "Over the next six to nine months, we will see early signs of a recovery."

Investors may already think the rebound is starting. While the Standard & Poor's telecom index lags the broad market for the year, it has rallied of late. The telecom group is down 32% since Jan. 1, compared with a 20% decline for the S&P 500-stock index. But measured over the past four weeks, telecom stocks have gained 11%, compared with 3% for the S&P 500.

Telecom's improving outlook is largely due to its closer ties to the economy. For decades, telecom services were mostly voice calls. Demand grew mostly with the size of the population. Now, telecom is a more complex critter with all sorts of new services--everything from speedy Web access into homes to robust data networks for corporations. Since 1998, data has accounted for well over half of all telecom traffic. So as the economy improves, consumers and companies are apt to spend more on discretionary services.

Moreover, the underlying growth in demand for telecom is much stronger than most people thought. In November, the Commerce Dept. issued a report on the value added to the U.S. economy by various industries--that is, their total output of goods and services minus the value of the inputs they used. The report showed that the value added by the telecom-service sector rose 12% last year. While that was below the 14% growth of 1999 and 2000--before the recession hit--it was much faster than the 6% growth that the industry averaged earlier in the 1990s. The upshot? Once telecom works out its pricing and debt problems, it should benefit from strong demand.

In fact, some prices are stabilizing or even rising. Weaker carriers have gone bankrupt, easing some of the pricing pressure that squeezed the industry. In most markets, prices fell 2% to 4% from April to October, according to market researcher TeleGeography Inc.--a much more modest decrease than the 70% annual drops in 2000 and 2001. Prices along the Atlanta-New York route actually rose 4.6%.

Spending on broadband is picking up, too. During the third quarter, Comcast Corp. (CMCSA ) and AT&T Broadband, which are now one company, added 342,000 new cable-modem subscribers, their best showing ever. Industrywide, the number of residential broadband subscribers grew 66% during the third quarter. As the need for capital spending on broadband slows down, telecom companies will start to profit from the service.

Financial results are improving for a handful of carriers. Vodafone Group (VOD ), the world's largest telecom player, reported better-than-expected results on Nov. 12. It cut its loss for the first six months of the year to $7 billion, about half the loss of a year ago. It also forecast stronger than expected subscriber growth of 10% this year. Vodafone shares rose 10%, to $17, in a single day. On Oct. 24, wireless carrier Nextel Communications Inc. (NXTL ) reported its second consecutive quarterly profit--after 10 years of losses. Nokia (NOK ) CEO Jorma Ollila said handset sales will rise 10% to 15% annually over the next few years--better than the single-digit increase analysts had expected. "What it says is that even in a very highly competitive industry, a differentiated product can be successful," explains analyst Craig Mallitz of Legg Mason Wood Walker Inc.

New services could also boost revenues. After years of broken promises, the wireless industry is rolling out a new generation of handsets with color screens, cameras, and Internet connections that are as fast as a 56K modem. They follow the introduction of higher-speed mobile-Internet services during the spring and summer, which helped spike usage 25% this year, according to Joseph McCabe, chief financial officer at AT&T Wireless Services Inc. (AWE )

None of this is to suggest that the pain for this industry is ending. But as telecom winds up another dreadful year, it appears that the worst is over.

By Steve Rosenbush, with Peter Coy, in New York

— With assistance by Peter Coy

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