By Ari Bensinger The communications equipment sector is heavily dependent on capital expenditure growth by telecommunications service providers. Following impressive growth of over 30% in 2000, carrier capital spending is expected to decline in the low teens in 2001. Mirroring the spending downturn, the S&P communications equipment index has fallen nearly 40% as of mid-May.
What caused capital spending growth to fall off a cliff in 2001? Let's take a look.
CAPITAL CRUNCH. The traditional service provider business model is not producing an adequate return on capital. The average revenue growth for these operators during 2000 was in the low to mid-single digits. With capital spending rates climbing well ahead of revenue growth, shareholders began to raise questions about the carrier's ability to recoup network investments. Access to capital became scarcer, and previously over funded competitive local exchange carriers (CLECs) began to fall to the wayside.
While CLECs represent a relatively small amount of the total capital spending market (under 10%), their exit from the market significantly lessened the competitive pressure on the spending heavy incumbent carriers (ILECs) to upgrade their legacy networks.
Looking forward, S&P expects industry consolidation to start occurring over then next few years. Some emerging service providers will go bankrupt while others will be acquired. Although consolidation will help improve return on capital for service providers, it will negatively impact equipment vendors, as a few large players tend to spend less than several smaller companies.
INVENTORY BULGE. During early 2000, equipment system makers stockpiled components to meet the robust demand that they were experiencing in a capacity constrained environment. The rapid drop in carrier spending in the third quarter of 2000 subsequently led to significantly overstocked distribution channels. In fact, many equipment vendors were in the midst of ramping-up manufacturing capacity when the slowdown hit. The excess inventory stalled sales and heightened pricing pressures.
The extent of excess inventory depends on specific product area and end market demand. For example, in the optical domain, passive components have experienced extremely high levels of excess inventory, while active components, which have longer lead times, have not been impacted by excess inventory as of yet.
Overall, even considering the titanic $2.4 billion inventory write-off from major equipment maker Cisco Systems, we estimate that it will take at least six months to work through all the excess inventory in the channel.
The rapid growth in capital spending over the past two years has caused a capacity overhang issue in the core of the transport network. Most optical networks are running at only 35% to 50% of total lit capacity. Indeed, Nortel Networks, which accounts for the majority of the long haul optical market, announced that its long haul product sales fell 60% in the most recent first quarter. Given that capacity utilization typically increases two to three points every month, we would expect the long haul optical market to remain weak until 2002.
To help increase capacity, carriers are focusing on alleviating the bandwidth bottleneck in the metro area. The optical metro market, albeit very small, will be one of the few areas of high growth for 2001.
Despite a temporary downturn, the communication equipment sector is an enormous market (around $300 billion) where opportunities remain robust. Products that help carries increase efficiency and create revenue-generated services will continue to see strong demand. For example, Ciena Corp. which focuses on less costly, more efficient next generation optical networks expects to grow 2001 revenues 95% to 105% in this difficult environment. Certain specific markets like metro core, optical switching, and voice over IP will prosper in 2001.
AN UPTURN? So when will carriers begin to spend again? Given the extremely poor visibility, no one really knows. Companies have not identified the first quarter as being a bottom. We will look for key industry metrics like a return to more normal inventory levels, an acceleration in order bookings, and an upsurge in sequential quarterly revenue growth as signs of improving industry fundamentals.
However, for now, given the tight capital market as well as excess inventory and capacity issues, we would stay on the sidelines. Bensinger is a telecommunications equipment analyst for Standard & Poor's