Communications Gear's Strong Signals

With pent-up demand finally manifesting itself in a rash of orders, the industry's stocks are up. It's a trend likely to continue

After a five-year slump, communications-equipment stocks are coming back to life. Since the year started, the S&P Communications Equipment index has risen 7.2% (through Jan. 20), after dropping 22% for the last five years. "Finally, service providers are spending enough money on their networks again," says Ari Bensinger, who follows communications equipment stocks for Standard & Poor's Equity Research. "So fundamentals are looking up."

Bensinger recently spoke with BusinessWeek Online's Karyn McCormack about cable providers entering voice services and its impact on equipment makers, as well as his favorite stock in the hot VoIP area. Edited excerpts from their conversation follow.

Note: Ari Bensinger is a Standard & Poor's Equity Research analyst. He has no ownership interest in or affiliation with any of the companies on which he writes research. 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 in this story.

Where do the cable operators stand in offering voice services and VoIP?
To compete effectively, service operators have to offer a complete array of voice, data, and video (See BW Online, 11/4/05, "The "Triple Play" in Communications Gear"). Accordingly, cable operators have begun to offer phone service through VoIP to bundle with their television video and high speed Internet access, potentially reducing churn and increasing revenue per subscriber. We estimate that cable VoIP surpassed 2.5 million customers at the end of 2005.

Among the specific operators, Time Warner (TWX ) and Cablevision (CVC ) are the biggest proponents of the service. Time Warner has over 1 million subscribers and Cablevision is closing in on that point, by our estimation. Comcast (CMCSA ) has a 1 million subscriber target for 2006; the company had 200,000 subscribers at yearend. Since Comcast is the biggest cable operator, they're a big catalyst for the market.

One point that I'd like to make is the transition to VoIP is just beginning. Penentration rates are very low, which indicates significant room for expansion.

Which companies are the top providers of equipment for these voice services?
The equipment necessary for VoIP includes video servers, switching, media gateways, customer premise equipment, set top units, and backbone unit transport. So that covers a lot of industries.

In terms of company size, the largest cable equipment supplier is Scientific-Atlanta (SFA ). Motorola (MOT ) and Cisco Systems (CSCO ) also provide cable equipment, but have other businesses that they focuses on.

There has been some recent industry consolidation, with Cisco agreeing to buy Scientific-Atlanta for $6.9 billion. We expect this deal to be approved in February. So these companies are the largest suppliers, but are not pure plays for VoIP.

The pure plays that supply equipment to the market are Arris Group (ARRS ), Harmonic (HLIT ), and C-COR (CCBL ).

Which one is the best positioned?
My colleague Ken Leon follows Motorola, and he has a strong buy recommendation on the stock. I have a buy opinion on Arris Group, and Harmonic and C-COR are both a hold.

Arris Group is situated at the sweet spot of IT spending -- VoIP. It has leading market shares in the CMTS (cable modem termination system) and E-MTA (embedded multimedia terminal adapter) areas. These are the critical pieces of equipment needed to deliver cable telephony. We think the company is experiencing strong momentum. It has significant operating leverage in its model and has a compelling valuation. Our price target for Arris is $13, and stock is currently around $11.

Besides voice and VoIP, are there other areas or trends that could give equipment stocks a lift?
There are potential new disruptive technologies like IP television (See BW Online, 10/4/05, "IPTV: Big Potential -- but When?"), fiber to the premise, and WiMAX (worldwide interoperability for microwave access). These technologies are beginning to gain widespread acceptance and the equipment providers that are able to adapt to the changing traffic will be presented with significant growth opportunities.

Just in the last few weeks, communications equipment stocks have been rising. How come?
The industry has faced some significant challenges and has underperformed the market for the last 5 years. Finally, service providers are spending enough money on their networks again. So fundamentals are looking up. The driver for the market is bandwidth, which drives new network builds and upgrades, spurring sales of new communications equipment.

We think the proliferation of all the services that we touched on above will increase the available network bandwidth -- meaning the service providers have to buy new equipment to upgrade their networks. There's a strong underlying growth driver that should help the industry. So essentially, the index has underperformed, but now things are improving.

READER COMMENTS

All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report.
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