Telecom Equipment: Waiting to Connect
By Ari Bensinger
The communications-equipment industry is undergoing a painful contraction as its primary customers, telecom-service providers, face declining revenue growth and capital constraints. With an increased emphasis on cash-flow generation, telecoms are lowering their capital budgets and buying new equipment only when absolutely necessary. Furthermore, they're increasingly reallocating capacity by shifting resources within their networks to fill immediate needs. Following a 15% decline in 2001, U.S. telecom spending plummeted by an estimated 60% in 2002 (see BW Online, 2/4/03, "Wrong Numbers for Telecom-Gear Makers").
Although the worst isn't over, the end of the equipment providers' plight may be in sight. Standard & Poor's estimates that U.S. carrier capital spending for new communications equipment will begin to stabilize by late 2003. Some carriers, such as Verizon (VZ ), have announced spending plans that are fairly close to last year's levels or down only slightly. For the short term, spending will shift from equipment that increases capacity to equipment that reduces operational expenses and enables carriers to provide new revenue-generating services.
Investors may get a better idea of when the industry's sales may finally hit bottom when equipment vendors report results for the quarter ending in March -- typically the year's weakest period for the industry. We at S&P expect revenues for most equipment outfits to decline 15% to 20% in the current quarter from the quarter ended in December.
In S&P's view, the industry seems to be approaching a better balance between supply and demand after the massive communications-network buildouts during 1999 and 2000, and the sharp cutbacks in spending that followed in the last two years. Service providers are now allocating less than 20% of their revenues to capital-spending projects, vs. more than 30% of revenue at peak spending rates in 2000. Though the providers are spending less, the level of spending vs. revenue is more sustainable, making it easier to forecast sales for the equipment industry.
More important, network utilization rates (the percentage of bandwidth being used in a given network) for the larger metropolitan areas are slowly creeping toward 70%. Typically, as the rate expands past the 70% comfort level, service providers are forced to invest in the network to maintain its quality of service in case of equipment failure. If telecom carriers push off infrastructure investments for too long, service quality could deteriorate and customer churn will likely increase. Also, from a competitive standpoint, telecoms are facing pressure from cable operators rushing to launch phone services combined with broadband Internet access and cable-TV.
With the wireline market contracting, investors should keep a close eye on the wireless sector. According to leading telecom researcher IDC, wireless will account for approximately 45% of worldwide telecom revenue in 2006, up from 38% in 2002. Indeed, in recent quarters, wireless provided roughly 40% of revenues for major wireline equipment makers Lucent Technologies (LU ) and Nortel Networks (NT ).
The wireless industry is rapidly moving to a new generation of network technology. While voice services drive investment decisions, data services drive network growth. For operators to gain revenue, they must be able to carry both conventional circuit-switched calls and packet-switched voice and data from a wide range of new sources, including those using Internet protocol (IP). Equipment vendors are scrambling to offer hardware and software that will help operators migrate quickly and as inexpensively as possible from their legacy systems to multiservice networks.
In the meantime, the sweet spot for equipment outfits is providing systems to both wireline and wireless service companies for so-called "enhanced services" such as voice mail, caller ID, three-way conference calling, one-touch call return, short-text messaging, and other personal-communications offerings. We at S&P believe enhanced services will become an increasing part of telecom spending, as carriers seek to add new revenue-generating applications.
Telecom operators benefit from offering enhanced services in two ways. First, they get added subscription fees and traffic revenue generated by the increase in completed calls. Second, the services help reduce overall traffic on networks, which can get bogged down by repeated busy or no-answer calls.
Comverse Technology (CMVT ), with an estimated 30% share, is the clear leader in the enhanced-services market. It provides software that allows more than 390 wireless and wireline service operators, including major companies such as AT&T (T ) and Verizon, to provide these new services.
The eventual progression to faster data speeds will greatly boost growth for Comverse's core market. However, the current operating environment remains weak, as telecom customers defer discretionary purchases such as replacement of competitors' systems and system-software upgrades. In addition, delays in next-generation wireless networks have postponed several significant growth opportunities.
A COMPELLING HOLD.
Following an estimated 40% decline in fiscal year 2003 (ending January) sales, we expect Comverse's sales to remain relatively flat at around $700 million in fiscal year 2004. We see the company posting an operating loss of 12 cents per share in fiscal year 2004, narrower than a loss of 34 cents per share projected for fiscal year 2003.
Given the weak telecom environment, we at S&P currently rate Comverse 3 STARS, or hold. However, we think the stock's valuation is compelling. Comverse shares -- which closed on Feb. 7 at $9.05 -- trade close to book value and slightly above Comverse's cash position of $9 per share. While the time isn't ripe yet, Comverse has all the makings of a prime turnaround candidate down the road.
Analyst Bensinger follows communications equipment stocks for Standard & Poor's
Edited by Karyn McCormack