Telecom Earnings Preview

Motorola warns of a loss in its handset business, but equipment vendors and service providers still should show healthy growth

Telecom companies, both service providers and equipment vendors, are expected to report relatively strong earnings gains in the second quarter, even though Motorola (MOT; $18; ranked hold by S&P) warned last week that poor sales of its wireless handsets in Europe and Asia will result in a loss for the period. The company also said it expects its mobile handset division, which accounts for about 60% of the company's sales, to report a loss in 2007.

While Standard & Poor's Equity Research subsequently downgraded its recommendation on Motorola shares to hold from buy, important trends in the telecommunications industry should benefit Motorola's other businesses, as well as other telecom equipment makers and service providers. "Motorola had a company-specific, wireless handset problem," says Todd Rosenbluth, an S&P equity analyst.

In addition to mobile handsets, Motorola makes wireless broadband networking equipment and set-top boxes used to deliver TV programming over cable networks. Both of these businesses are seeing strong demand, which will help keep Motorola afloat while it tries to return its handset business to profitability.

Motorola's Connected Homes division, which makes set-top boxes, reported revenue growth of 42% in the first quarter of 2007 compared with a year earlier, and is expected to post further, though smaller, gains in the second quarter. Networking titan Cisco (CSCO; $30; ranked hold), which bought set-top box maker Scientific Atlanta in 2005 for $6.9 billion, should benefit from the same trend, says Ari Bensinger, an S&P equity analyst.

Networkers Stand to Gain

"For telecom equipment vendors, there are two primary factors driving growth," Bensinger says. "There is competition between the cable operators and telecom service companies, which means they have to spend more on their networks or risk losing market share. Also, there is the proliferation of video traffic on the Internet, which is causing constraints in bandwidth" and also forcing carriers to upgrade their equipment, he says.

Companies that should post the strongest gains from this trend, Bensigner says, are F5 Networks (FFIV; $88; ranked buy) , which makes software that eases the flow of video over the Internet, and Netgear (NTGR; $39; ranked hold) , which makes wireless networking routers that allow customers to transfer video and sound files between their computers and TVs.

"F5 is a video transport play," Bensinger explains. "Their products enable the network to make more intelligent switching decisions, and they are gaining significant market share at the expense of established vendors like Cisco. Because their products are more software-oriented, they are very high margin—above the industry average." On the other hand, Netgear is more involved in wireless routing.

Getting the Fiber-Optic Payoff

To fend off cable operators, the largest telecom service operators, Verizon Communications (VZ; $43; ranked hold), and more recently AT&T (T; $40; ranked hold), are building fiber-optic networks that, in the case of Verizon, go directly into the home, and with AT&T get close to it. While these networks are enormously expensive to build, requiring billions of dollars in capital spending, Verizon is starting to generate meaningful revenue from its fiber-optic service, called FIOS.

"Verizon is much further along," says Rosenbluth. "They're not just testing and taking small steps. It's a meaningful contributor to the business. It's still costly and pulling down their operating margins, but we think things will have improved during the second quarter in the cost structure and it will be less of a drag."

Equipment vendors that will likely benefit from the construction of fiber-optic networks include ADC Telecommunications (ADCT; $20; ranked hold), which makes equipment needed to bring the fiber-optic cable into the home, and Corning (GLW; $27; ranked strong buy), which makes optical fiber and cable.

Moving Fast for Customers

Telecom service providers probably won't show the gains that equipment vendors will, due to their large capital spending requirements to build out their broadband networks, and the slow, but steady loss of customers to cable operators. "It's not a revenue growth story for telecom carriers," Rosenbluth says. He expects carriers to post stable to low-single-digit growth in revenues. They should also show lower costs by paring their large workforces, streamlining businesses, and merging with other carriers to reduce overhead, he predicts. Share buybacks should also help boost earnings per share, he says (see, 7/9/07, "Hold the Line on Telcos").

Because the operating environment for telecom services is so competitive, companies are moving to get professional help in dealing with customers, benefiting companies like Amdocs (DOX; $39; ranked strong buy), which provides billing and customer care software to both telecoms and cable operators. "This quarter, we think they are going to benefit because Sprint Nextel (S; $22; ranked sell) is moving customers onto its platform," Rosenbluth says, in an effort to compete better with its two main wireless rivals, Verizon and AT&T.

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