Stronger Signals for Networking Stocks

Growing demand from enterprise customers is helping to offset sluggish sales to telecom carriers

Investor enthusiasm for networking stocks waned after several companies reported that weak spending by large telecommunications carriers, particularly for wireless products, would cut into profits. These announcements highlighted the companies' heavy dependence on a small group of very powerful customers.

While the carrier business has yet to regain the strength it showed in the 1990s, sales to another main customer group, "enterprises"—such as businesses, hospitals, and universities—appear to be gaining momentum, a trend that would benefit a number of companies. For the quarter ended Sept. 30, Avaya, which sells almost exclusively to enterprise customers, said its revenue jumped by about 12% compared to the previous quarter. This increase signaled stronger demand from these customers, which account for about one-third of all communications equipment sales.

Enterprise Spending

Avaya is the leading vendor of switchboards found in business and governmental offices. Because sales of such products have typically grown slowly, Standard & Poor's Equity Research believes the surge in revenues reflects increased spending by enterprise customers, and that should benefit many networking equipment companies for years to come.

"The quarterly sales increase was one of the strongest revenue growth rates that we have seen from the company in some time," says Ari Bensinger, an S&P equity analyst. Avaya's sales are very broad-based, so "it shows that enterprises are spending," he said.

Much of Avaya's growth came from orders for new lines that send traditional telephone traffic over Internet connections instead of the telephone company's circuit-switched network. Avaya installed a record number of new lines in the quarter—its sixth consecutive quarter of selling more than 1 million new lines. Those new lines are being used by companies for advanced communications applications that require more bandwidth, more and bigger routers, and a whole host of other networking gear.

Avaya shares ceased trading Oct. 25 when the company's sale to two private equity firms was completed, but there are other ways for investors to play the enterprise trend. Other companies that could benefit include Cisco Systems (CSCO), the leading maker of routers and switches and also a competitor to Avaya in the switchboard market, as well as F5 Networks (FFIV) and Netgear (NTGR).

Upgrade Cycle

Cisco has such a vast product line that it will inevitably benefit as communications traffic grows and becomes more sophisticated, according to Bensinger. The company is particularly interested in capturing the rising demand for video traffic, Bensinger says, and takes every opportunity to highlight its work in the area. While it's still in "the beginning stages," video traffic "is probably the most important growth driver for the future," he says. The stock is ranked 4 STARS (buy) by S&P.

Seattle-based F5 Networks should also be able to capitalize on the growing traffic trend. The company is the leader in application delivery networking, or the delivery and use of software programs over a network. F5's network switches can analyze data traffic and deliver it to a group of connected servers in ways that enhance the performance of the entire system. "Companies want more intelligence in the network. They want their routers and the switches to do more, with added applications like wireless access, security, and traffic optimization," says Bensinger, and F5 products specifically target those needs. F5 is also ranked 4 STARS.

Netgear focuses on small- and medium-sized business customers, as well as home users of networking equipment. The company makes more "low-end products at attractive pricing points," says Bensinger, but he thinks the business will pick up as customers install new wireless networks. Netgear carries a ranking of 5 STARS (strong buy).

The last large-scale round of communications upgrades was in 1999, Bensinger says. Most networking products, including switches and routers, are only designed to last for five to seven years, so most of that equipment is nearing the end of its useful life. "Businesses can only postpone these upgrades for so long," he says. "We expect a gradual, but very large, broad-based upgrade cycle. This is a long-term upgrade cycle, which should fuel the market for the next couple of years."

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