Telecom's Chronic Disease: Slow Growth

Capital spending is sagging, and prices are being competed downward. Worse, the sector's troubles won't be ending any time soon

By Steve Rosenbush

It has been rough going for the telecom-equipment industry since the tech bubble popped in 2000, but many companies have cut costs and cleaned up their once-precarious balance sheets. Result: Major telecom vendors such as Lucent Technologies (LU ) and Alcatel (ALA ) are profitable again and have plenty of cash.

The outlook for growth is less encouraging, however. Capital spending on telecom gear has slowed during the second half, raising concerns once again. No one is predicting a return to the grim days of the telecom bust, when spending tumbled as much as 30% a year. But 2004's growth rate is unlikely to be sustained in 2005.


  On a global basis, Bear Stearns expects telecom spending to rise 6.6% this year, to $140 billion, but for 2005, it projects an increase of only 4.9%, to $147 billion. The problems appear concentrated in the second half of 2004. Spending from January through June was 18% higher than during the first half of 2003. But outlays in the second half will be 3% lower than the year-earlier period.

A number of reasons account for the downturn. The rise of cheap, Internet-based phone services is driving revenues for telecom carriers lower. Cable-TV operators also are getting into the phone market, and this competition adds another source of price pressure. On top of this, a fast-changing environment in the U.S. is making it tough for outfits like AT&T (T ). The telecom giant is scaling back its consumer business, which means it needs less equipment.

Although the overall economy is growing, it has come down from the peak levels of earlier this year. Many businesses are still cutting jobs or refusing to hire, and this hurts telecom demand. While residential phone use is relatively constant, the demand for business services is a function of the number of workers sitting in offices and cubicles.


  More trouble could be ahead for telecom-equipment producers. And the spending downturn may not yet be figured into investors' expectations. Bear Stearns notes that the consensus expectation on Wall Street is that gear makers' revenues will rise 11% in 2004 -- way above the 6.6% increase in capital spending that the brokerage has forecasted for this year.

These days, such manufacturers have other sources of revenue, such as services and outsourcing. But even so, Bear Stearns warns that with rising inventories and a lack of meaningful consolidation, a "moderate earnings shortfall," is possible -- especially for suppliers with heavy exposure to North America and to wired networks.

Telecom's business environment in the U.S. is particularly rough. Analyst Susan Kalla of Friedman, Billings, Ramsey originally expected U.S. capital spending on telecom equipment to rise 3%, including wireless. She now expects it to fall 8%, to $54.3 billion. She anticipates it will drop further in 2005, to $51 billion, before rising again to $52 billion in 2006. "It's like a war zone in the U.S," says Kalla.


  The domestic telecom market has been flooded with used equipment in recent months. Outfits such as AT&T and Qwest (Q ) have been auctioning off such items, says John Lynch, vice-president for purchasing at Asset Recovery Center in Milford, Conn. He expects PSINet to auction off 2,500 lots of equipment during the next few months at about a 20% discount off the original purchase price. That could depress margins and boost inventories of new gear, Lynch says.

When will the industry's troubles truly end? They probably won't. New regulations and technologies like the Internet and wireless have put prices on a sustained downward spiral. Companies can cut costs and develop new services, but this won't be enough to generate huge growth gains.

Innovative products, such as voice over Internet Protocol (VoIP, technology that transmits voice calls over the Net), won't solve the industry's financial woes, either, since they're quickly becoming commodities. The price of VoIP, which was $35 a month last year, already has dropped to $20.

Perhaps the best way to view the telecom industry is as a patient battling a chronic disease. It will be able to survive indefinitely -- but will require constant care.

Rosenbush is a senior writer for BusinessWeek Online in New York

Before it's here, it's on the Bloomberg Terminal.