High Hopes for High-Speed Access

Broadband growth will benefit DSL providers more than cable, and that trend makes Adtran a likely winner

By Ari Bensinger

Increased Internet use is fueling strong demand for broadband access technologies. Cable modems and digital subscriber lines (DSL) are currently the broadband technologies of choice, and each is rapidly building a broad subscriber base.

Globally, growth prospects appear bright, as worldwide broadband Internet access remains limited. At the end of 2002, only 20% of total households worldwide with Internet service were estimated to subscribe to broadband services. According to a study by Internet measurement firm Nielsen/NetRatings, less than 50% of the U.S. online population is covered by broadband, and the country ranks only 11th in worldwide broadband usage.


  In terms of network speed, the core, or long-distance, portion of the telecom network was upgraded in 1999 and 2000 to enable it to carry billions of kilobits of data per second. However, consumers are still largely connected through dial-up modems that transmit at 56 kilobits per second. As with the water supply, no matter how much you widen the underground pipes, the flow to the consumer depends on the width of the faucet.

To give consumers better data access, telecom service providers have begun to shift their spending priorities toward the last mile, or the "edge" of the network, aggressively adding DSL lines and equipment that transform copper wire into high-speed digital channels. With most of the early adapters having already migrated to DSL from Internet dial-up service, operators are now targeting the mainstream market with lower DSL access fees and higher data speeds.

According to independent communications networking research firm Dell'Oro, global DSL subscribers totaled 61 million in 2003, up 77% from the prior year, with an average increase of more than 2 million people per month. The industry should continue to benefit as consumers increasingly defect from slower dial-up connections. We believe that DSL growth prospects remain bright, as only 5% the world's main phone lines are delivering such services.


  At of the end of 2003, the U.S. had more than 11 million DSL subscribers, or about 20% of the global broadband-subscriber market. This represents growth of 40% from the 8 million subscribers garnered in 2002. The incumbent local exchange carriers, which serve approximately 90% of the total subscriber base, have an overall customer mix that's typically 80% residential and 20% business.

Over the long term, telecom carriers should eventually install bandwidth-rich fiber all the way to customers' premises. However, given the still-high price of installing fiber to the home, we believe that DSL is currently the best alternative for telecom carriers to capture broadband customers.

So how does an investor play this trend in the communications-equipment sector? We believe the most logical candidate is Advanced Fibre Communications (AFCI; 4 STARS, or accumulate; recent price: $20), which derives most of its revenue from DSL-related services. The company agreed to be acquired by Tellabs (TLAB: 4 STARS; $9) in late May. We expect AFCI's performance to be largely tied to its acquirer's growth prospects more than underlying industry fundamentals.


  With leading positions in the access-equipment market, network-equipment manufacturers Alcatel (ALA; 3 STARS, or hold, $15) and Cisco Systems (CSCO; 5 STARS, or buy; $23) seem like solid DSL plays, in our opinion. However, given their multibillion-ollar communications-equipment revenue base, DSL-related sales account for only a small portion of the overall business and will probably not solely move the stock price.

We believe a promising play in DSL is mid-cap access-equipment maker Adtran (ADTN; 4 STARS; $33). Its core business is dependent on growth in T-1 (a leased-line connection capable of carrying data at 1.54 megabits per second), which is decelerating because of line losses at the incumbent carriers.

However, Adtran's sales of digital subscriber line access multiplexer (DSLAM) equipment, the gear that takes connections from many customers and aggregates them to a single high-capacity connection, are ramping quickly. The company's DSLAM products are firmly entrenched with five of the seven largest carriers in the U.S., despite having entered the market only a couple of years ago. We expect revenue from DSLAM equipment to more than double in 2004, to more than $60 million, from the prior year. By Ari Bensinger


  For 2004, we expect Adtran to post robust revenue growth, based on its strong cost-leadership position. Overall, we see 2004 sales advancing 24%, to $490 million, reflecting strong capital spending by the outfit's carrier and enterprise customers. Visibility remains low for Adtran, as products are delivered with very short lead times. Still, with its established customer base continuing to shift spending priorities to the access portion of the network, we're confident that Adtran can meet our revenue estimate.

Benefiting from improved manufacturing efficiencies and increased high margin sales, Adtran's gross margins are expected to widen to the 56% level, above its 55% operational target. As a result of cost-cutting, operating expenses are likely to decline as a percentage of sales during 2004. Overall, we see 2004 operating earnings per share of $1.02, vs. the 76 cents earned in 2003.

From a valuation perspective, Adtran stock trades at 5 times our 2004 sales estimate, well above the peer average. However, we believe this premium sales multiple is somewhat justified by Adtran's wider gross margins, which are more than 40% above the peer average.


  Our 12-month target price of $37 is largely based on a forward p-e multiple of 36 times our 2004 EPS estimate of $1.02, a 15% premium to the industry average. We believe a premium p-e is warranted because Adtran has consistently exceeded its earnings guidance during the past two years. When compared with our 18% long-term earnings-growth estimate for the company, the target price represents a forward p-e-to-growth ratio of 2 times, in line with the peer mean.

We think that the attractive DSL market opportunity that's available to Adtran is not appropriately reflected in the stock price, and we would accumulate positions. The primary risks to our recommendation and target price include a slowdown in broadband subscriber growth, an overcapacity in the supply of broadband access concentrator port equipment, and the loss of a major incumbent local exchange carrier customer.

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. (SPSI). Affiliates of SPSI received non-investment banking compensation from Advanced Fibre Communications and Cisco Systems during the past 12 months. Price charts and required disclosures for all STARS-ranked companies can be found at www.spsecurities.com

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

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