This Tech Market Is Really Connecting

Communications equipment makers finally have some promising prospects, such as VoIP and 3G telecom services. And investors are noticing

By Ari Bensinger

After a 65% advance in 2003, the Standard & Poor's Communications Equipment index has climbed 15% year-to-date through Jan. 23, vs. a 2.9% gain for the S&P 1500 index. In our opinion, this impressive performance reflects investors' increasing confidence that spending on telecom and enterprise technology is beginning to firm from a severe downturn over the past two years. While an imminent rebound in communications-equipment spending is debatable, we believe the market clearly has certain pockets of growth.

A noteworthy trend in the communications-equipment arena is local number portability (LNP). The Federal Communications Commission ruled that starting November 24, 2003, all wireless service providers must implement LNP. Defined under the 1996 Telecom Act, LNP enables consumers to retain a phone number when they switch wireless carriers or from wireline to wireless within the same general metropolitan area.


  For equipment vendors, the mandate will likely compel wireless carriers to place extra emphasis on their networks' quality, fueling increased infrastructure investments. In addition, handset sales should benefit from increased industry churn now that consumers won't have to lose their phone number when switching carriers. (Consumers typically buy a new handset when they get a new service provider.)

Wireless-network vendors should also benefit as operators worldwide begin to deploy the large number of base stations needed to meet the demands for advanced third-generation (3G) wireless-equipment users. Industry research outfit Dell'Oro projects the WCDMA (wideband code division multiple access) network -- one of the three technologies for 3G -- growing 54%, from $3 billion in 2003 to $4.6 billion in 2004. In the near term, WCDMA products will likely experience intense pricing pressure as vendors aggressively compete to establish a network footprint.

The full promise of 3G products may not materialize in the consumer market for a few more years, with Europe leading the way and the U.S. market lagging. In the meantime, several transitional technologies, known as 2.5G, are being developed to offer faster data speeds than are now available.


  Another trend is the transition to packet switching. Largely because of the proliferation of the Internet and related data applications, the communications market is shifting from traditional circuit switching to packet-switching technologies. Since circuit switching requires a specific path or channel to be dedicated for the entire time that information is transmitted, it's poorly suited for data traffic's tendency to travel in bursts. Conversely, packet-switching technology utilizes bandwidth more efficiently by supporting both voice and data simultaneously and by not consuming network resources when no information is being sent.

Perhaps the most important attribute of packet switching is its ability to offer new multimedia services to the mature telephony market. Yet despite its advantages, the transition to packet switching will likely be very gradual, as circuit switching is well entrenched within the industry and has delivered near flawless voice service for more than a century.

Voice over Internet protocol (VoIP), which enables the transmission of voice traffic over a packet-switched data network like the Internet, is quickly becoming incorporated into consumer and hardware software (see BW Online Special Report, "Finally, 21st Century Phone Service"). For example, Cisco Systems (CSCO ) has developed VoIP handsets, and Microsoft (MSFT ) has embedded voice capability into its instant-messaging software. Several broadband providers, while limited in scale, have launched commercial VoIP service.


  Most important, VoIP stands to open the telephony market to new competitors that no longer need a phone line to offer service. Cable operators, in particular, are well positioned to benefit from VoIP technology, having recently spent billions of dollars to upgrade their networks to handle two-way digital traffic. The evolution of "data over cable service interface specifications" (or DOCSIS) has paved the way for broadband cable telephony. New DOCSIS 2.0 technology improves the customer's signal to the network while maintaining high network service quality.

Although VoIP remains an unproven technology that's perceived to have lower voice quality and reliability than the public switched phone network, it can potentially become a disruptive force. VoIP creates a significant new market opportunity for equipment companies that can help cable operators make the evolutionary transition toward voice services.

Meanwhile, cable companies are launching new services. To combat recent partnerships between the regional Bell and satellite operators, which allow the telecoms to offer video service, cable operators are aggressively launching enhanced services such as video on demand (VOD), high-definition television (HDTV), and digital video recording. By Ari Bensinger


  As the quality and reliability of voice transmission over cable improves, operators will likely increase their focus on the enormous phone-service market. By using the IP platform, cable players would be able to offer significant voice price discounts without sacrificing margins. Offering voice through cable telephony would also allow operators to bundle TV, high-speed Internet access, and phone service in a single package, potentially reducing customer churn and increasing average revenue per subscriber.

The final trend to watch is fiber to the premise (FTTP), also known as fiber to the home. The nation's three largest phone companies -- Verizon (VZ ), BellSouth (BLS ), and SBC Communications (SBC ) -- have begun accepting equipment proposals for FTTP network launches. The potential size of the investments remains unclear, however, and may depend on the outcome of current regulatory deliberations regarding competitive access to telco facilities.

The transition to bandwidth-rich FTTP will allow the Bells to bundle video along with voice and high-speed Internet services to better compete with the cable and satellite operators. The FTTP initiative should eventually benefit the equipment makers that focus on fiber cable and hardware, optical components, HDTV hardware and software management, and personal recording set-top boxes.


  Today, installing fiber to the home, including the digging and trenching, is extremely costly. The Baby Bells are hoping that the potential of a massive fiber rollout will induce equipment makers to lower equipment prices drastically. S&P believes widespread fiber to the home is still years away and that any potential orders will likely focus on new high-end residential community buildouts.

Our favorite stock in the group is wireless-handset maker Nokia (NOK; ranked 5 STARS, or buy; recent price: $20.66). We believe it's well positioned to benefit from higher handset sales due to local number portability as well as increased wireless-network spending for 3G equipment. Despite a market-leading position, Nokia trades at a discount to peers on a price-to-earnings valuation.

On the networking side, we believe Avaya (AV; 3 STARS, hold; $17.39) could potentially benefit from an accelerating transition toward packet switching and Internet telephony. However, due to the recent steep appreciation in its stock price, we view it as fairly valued.

On the cable front, we view C-Cor.Net (CCBL; 4 STARS, accumulate; $16.47) as an attractive play on cable operators' aggressive launch of new services. Its high-margin software products, which support services like VOD and VoIP, showed significant growth in the December quarter.


  Although the communications-equipment industry is still suffering from low capital spending by telecom operators and other large corporations, S&P thinks prospects are promising. The market's underlying growth driver is the demand for bandwidth, which creates the need for new network buildouts and upgrades and spurs sales of new communications equipment.

As Internet users move toward higher-speed connections, bandwidth demand will increase dramatically. Greater access to bandwidth will lead to newer and more powerful applications, such as multimedia video, interactive TV, and VOD. These applications will drive still more thirst for bandwidth.

Note: Ari Bensinger has no stock ownership or financial interest in any of the companies in his coverage area. He's a registered representative of Standard & Poor's Securities, Inc. Other S&P affiliates may provide services to the companies under discussion.

Analyst Bensinger follows telecommunications equipment stocks for Standard & Poor's Equity Research

Edited by Karyn McCormack

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