Networking Gear: New Arenas, Iffy Stocks

Cisco's WebEx deal shows it's moving beyond hardware, but overall, prospects for shares of communications equipment companies are uncertain

Cisco Systems' (CSCO) recently announced $3.2 billion deal to acquire WebEx (WEBX) will take the bellwether communications equipment maker beyond routers and switches that transport voice and data over networks, to applications software—putting it directly in Microsoft's line of fire (MSFT) (see, 3/16/07, "Cisco Ups Ante in War with Microsoft").

"This evolution stems from Cisco's longstanding vision that networking will evolve from a simple transport medium into an intelligent communications system," says Ari Bensinger, who follows communications equipment stocks for Standard & Poor's Equity Research.

Indeed, equipment suppliers are faced with the constant threat posed by new technologies, Bensinger says, with traditional products regularly replaced by more efficient and functional equipment. Some players are focusing on niche growth areas, such as components for electronic program guides and security in cable set-top boxes and video surveillance used in security systems. His two favorite stocks that are players in these areas are NDS Group (NNDS), based in Britain, and NICE Systems (NICE), based in Israel.

Though the industry is seeing strong demand overall for new gear to build fiber-to-the-home and Internet-protocol TV services, company sales visibility is low and can swing from one quarter to the next, Bensinger warns. In turn, communications equipment stocks could be on shaky ground this year.'s Karyn McCormack spoke with Bensinger on Mar. 27 about communications equipment companies. Edited excerpts from their conversation follow.

Note: Ari Bensinger is an S&P Equity Research analyst. He has no ownership interest in or affiliation with any of the companies that he researches. All of the views expressed here accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed.

What do you think of Cisco's plans to acquire WebEx?

WebEx is an interesting acquisition because it's primarily a subscription-based business and veers from Cisco's unit-driven revenue model. It seems like Cisco is gradually evolving from a hardware vendor that sells transport infrastructure equipment to a solutions provider of communication software and services. This evolution stems from Cisco's longstanding vision that networking will evolve from a simple transport medium into an intelligent communications system. An expansion into this market will set the stage for some desktop turf wars against Microsoft, a company that has not been a major competitor to Cisco before.

Do you see more deals in general among communications equipment companies?

There's certainly been a sharp increase in M&A [mergers and acquisitions] over the last two years. Some notable examples include Cisco acquiring cable set-top box maker Scientific-Atlanta and the cross-border combination of France's Alcatel (ALA) and U.S.-based Lucent. We believe these deals underscore the important role that convergence will play in the industry, as equipment vendors that cannot offer a complete solution to support voice, data, and video will be at a huge disadvantage.

Given that there are only a few large, integrated equipment suppliers left in the market, we believe that most transactions going forward will be on a smaller scale, mostly to fill product-portfolio holes.

Do you forecast stronger spending by telecom and cable companies for equipment to upgrade their networks this year? Which area is showing the most growth?

I think you have to segment the market by end users—that is, telecom operators, cable operators, and enterprise customers. In the telecom market, the majority of spending is still on the edge, or access, portion of the network. Suppliers offering fiber-to-the-home equipment are experiencing extremely strong demand as telecom operators aim to increase the speed of their network.

In the cable segment, voice-over-IP equipment is a hot market, fueled by cable operators' aggressive expansion into the consumer voice market. As for the enterprise space, businesses continue to upgrade their network to better handle data, video, and mobile applications. The markets for security and wireless applications are seeing strong demand.

What other trends are you seeing for the industry?

One thing that has been happening is there's very poor sales visibility. Given the uncertain timing of large, next-generation, network-driven projects, many equipment providers are experiencing lower sales visibility, which is having a negative impact on manufacturing plans. We expect to see extreme sales fluctuations quarter to quarter in 2007 due to the uncertain demand and timing of these projects, particularly for fiber-to-the-home and Internet-protocol TV.

Do you think this will affect the stocks?

It has affected the stocks. Investors have a "show me what you have done lately" mentality. For example, ADC Telecom (ADCT) and Adtran (ADTN) have seen sales fluctuate from Verizon's (VZ) fiber initiative.

If you look long term, year over year, there will be very strong growth. Operators are very committed to building out new networks. But quarter to quarter, you'll see some inconsistencies, as operators struggle to manage inventory due to the uncertain customer take-up rate related to these new technologies.

What are your favorite stocks?

We have a strong buy recommendation on NDS Group. It's a supplier of digital technology and services to digital pay TV platform operators and content providers that we think should benefit from competition between cable, satellite, and telecom operators as they race to offer advanced digital services. This company sells to companies like DirectTV (DTV) and international service providers.

We think NDS is successfully leveraging its leading market position in content security toward new software applications like digital video recorders and interactive gaming. The company's software systems and services are focused on the secure distribution of digital information and entertainment, and are integrated into set-top boxes made by most of the major consumer electronics manufacturers. We view the company's operating model as attractive, with a predictable recurring revenue base and high incremental margins.

We also have a 5 STARS opinion on NICE Systems. This company provides solutions that analyze multimedia content, which in turn enables companies to enhance their business and operational performance. It sells products that capture, store, retrieve, and analyze customer interactions to call centers, financial trading floors, and other businesses. It also provides advanced video surveillance and control services for the public safety and security markets. With an expanding customer base and significant operating leverage in their business model, we think NICE can post sales and earnings growth above peers for the next several years.

We view NICE's broad product portfolio and strong global presence as significant competitive advantages over the smaller specialty providers. We see the migration toward VoIP and a stricter regulatory compliance environment acting as strong industry drivers for NICE.

These two stocks are really under the radar.

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