Last October, as Cisco Systems Inc. (CSCO )'s first fiscal quarter drew to a close, CEO John T. Chambers realized that revenues weren't quite what he had been expecting. The head of the Internet equipment maker had been subjected to plenty of surprises during the past few years, but this was different: For once, the numbers were better than anticipated, not worse. What's more, the gains were strongest in the telecom market, which he had thought would recover more slowly than corporate networking. "It was a very pleasant surprise. Carrier capital spending was up 10% sequentially over the last quarter," he said.
The telecom downturn is over. U.S. telecom companies are expected to increase capital expenditures, a crucial measure of industry health, by 5% in 2004, to $58 billion in 2004, according to Lehman Brothers Inc. (LEH ) analyst Steven Levy. That's the first increase since 2000, and it's a welcome turn of events, even though the increase restores spending only to 1996 levels.
The revenue picture is getting better, too. Telecom-equipment revenue will grow 8%, to $190.5 billion, up from $177 billion in 2003, the first increase since 2000, according to telecom economist James Glen of Economy.com Inc. The services sector, which managed a 2.1% increase in 2003, will pick up the pace in 2004, expanding 4.7%, to $398 billion. Nearly all of that growth will come from the $100 billion wireless-services sector, which Glen expects to grow about 11%. Faster networks, lower prices, and hot new features such as gaming are driving cellular growth.
A few niche markets are on fire, too. The telecom sector is suddenly embracing networking technology based on Internet protocols. Sale of such equipment to big corporations hit an estimated $2 billion in 2003 and will grow 50% in 2004, according to Levy. Even as revenues pick up in such fields, heavy competition in most sectors of the telecom market is certain to put limits on profit growth.
What's striking is how the ordeal of the past three years has transformed the telecom industry. During the downturn, chief execs realized they had poor insight into many aspects of their operations, from customer demand to inventory and the supply chain. Now they have better information on all those fronts, thanks to improvements in the software tools and data links used to plan supplies and forecast sales. That allows them to react more quickly than in the past. "We're going to be operating in an environment where cycle times are dramatically compressed," says Scott Kriens, CEO of communications-equipment-maker Juniper Networks Inc. (JNPR ). "And that will change everything, from the business model to [raising funds]."
The changes in the business model will become more evident as 2004 unfolds. Companies are getting away from the old way of charging by the minute to transport voice and data over the network, for example. They're embracing flat-rate plans for everything from traditional voice to wireless and broadband. Moreover, those flat rates are falling. Broadband rates have already dropped as much as 50% in some cases, to about $30 a month, and they will continue downward in 2004. Rising competition and falling prices will be felt throughout the food chain, putting pressure on everyone from equipment makers to venture capitalists -- which means raising money will remain difficult.
The need to reduce costs has also hastened the adoption of telecom equipment based on Internet Protocol (IP), the underlying data standard of the Net. IP equipment is cheaper than traditional phone gear when it comes to voice traffic, and it can be adopted easily by cable companies who want to break into voice services. IP also lowers the cost of rolling out new services such as video calls, or instantly acquiring a second or third line. AT&T (T ), BellSouth (BLS ), Verizon (VZ ), and SBC Communications (SBC ) launched "voice over IP" (VOIP) services at the end of 2003, and others will follow suit in 2004.
Cable companies are also keen on IP technology. Activity in the cable arena picked up speed in December, when Time Warner Cable (TWX ) announced it would roll out IP-based phone capability to its 10.8 million subscribers from New York to Los Angeles by the end of 2004. To get started, users simply plug their regular phone into a cable box equipped with phone jacks. In one of the first markets -- Portland, Me. -- the company charges $39.99 to customers who agree to a bundle of services. "This is a business to keep an eye on," says says Time Warner Inc. CEO Richard D. Parsons. Analysts say cable phone subscribers will hit 3 million by the end of 2004, up from just over 2 million in 2003. And in three years, according to UBS Investment Research, phone service could account for $4 billion in new revenues for cable outfits.
A few days after Time Warner made its December announcement, AT&T said it would roll out IP phone service in up to 100 markets in 2004. But both giants are really following the lead of small pioneers such as Vonage Holdings Corp., and Net2phone Inc., which allow their customers to make unlimited local and long-distance calls over the Net for as little as $35 a month. Vonage CEO Jeff Citron says the advantages of VOIP include much lower operating costs and improved capabilities, such as the instant ability to conference as many as nine people together on a call. Those benefits haven't been lost on local-phone giants. "It's pretty clear to anyone who looks at this stuff that it's a more efficient way to run networks," says Verizon spokesman Eric Rabe. "We want to be part of it."
Ultimately, the new technology will change the way networks are designed. Today, carriers still have separate networks for regular and wireless phone service and various forms of data traffic. In the future, says Frank Dunn, CEO of Nortel Networks Corp. (NT ), carriers will have a single IP network over which voice, data, and wireless calls are all sent.
VOIP also raises a raft of new regulatory issues. Such services bypass the local-phone network and many of the levies that phone companies use to help offset the cost of phone service for low-income customers and locales with a sparse population. VOIP startups say it's too early to force more fees on their young industry, which accounts for less than 150,000 lines -- a fraction of the nation's total of 180 million lines. Tech luminaries such as Cisco's Chambers agree. "If you want to slow things down, the government could try to regulate IP voice," he says. "That would be a tremendous mistake."
Indeed, some say regulatory uncertainty is already slowing rollouts of VOIP to consumers. Still, adoption is brisk by businesses, which operate with less regulation, says Roger Heins, vice- president in charge of VOIP products at Lucent Technologies Inc.
In the end, the shift to IP technology will help telecom companies bolster revenue in an era of rising competition and falling prices. "CEOs are beginning to realize that cost-cutting can only do so much and that they have to invest in new sources of revenue," Chambers says. For equipment and service suppliers, that's something to bank on in 2004.
By Steve Rosenbush in New York