Markets & Finance

No Feeding Frenzy over Telecom Suppliers


By Ari Bensinger The communication-equipment industry is undergoing a painful contraction. Its primary customers, telecom-service providers, face declining revenue growth and capital constraints.

The sorry state of affairs is clearly evident in the industry's stock performance. Year-to-date through July 5, 2002, the S&P telecom-equipment industry subindex fell 45%, vs. a 13% decline for the S&P 1500 (the combined S&P 500, S&P MidCap400, and S&P SmallCap 600 indexes). And this comes on top of a dreadful 61% collapse in 2001.

The deteriorating operating environment has investors as bearish on communication equipment as they were euphoric only a couple of years ago. Onetime highfliers like Nortel (NT) and Lucent (LU) have seen their share prices fall below $2. Several depressed optical-equipment stocks are trading near or even below the per-share amount of cash on their balance sheets.

HOLD OFF? You would think these low stock prices would create an acquisition feeding frenzy. Potential buyers should be salivating over the myriad of blue-light specials available throughout the communications sector. But that's not the case at all. Interestingly enough, with the exception of the June, 2002, acquisition of ONI Systems by Ciena (CIEN), the sector has seen no significant wheeling and dealing.

It's clearly a buyer's market. And savvy shoppers will hold off buying now because the takeover targets' shares may be even cheaper down the road. When Ciena and ONI agreed to unite, the proposed deal was worth approximately $900 million. At the closing date only six months later, the acquisition was valued at approximately $400 million. In fact, the transaction price was less than ONI's $700 million cash position.

Standard & Poor's believes that the currently depressed market conditions will restrict any widespread merger and acquisition activity, for a number of reasons:

Slowing Innovation. Over the past couple of years, technical innovation in the communications-equipment industry has moved at light speed. Numerous companies were competing intensely to transport data traffic faster, farther, and more cost effectively. As soon as carriers began to deploy a product, another one quickly made it obsolete. Equipment makers that didn't keep pace with the technical curve instantly lost their customer base.

Often, it was easier and faster for companies to acquire an existing technology than develop it on their own. However, the current hiatus in customer spending is providing companies an extended period to develop their own technologies internally. The financial failure of several next-generation equipment makers reduced the number of new-equipment introductions and lessened the competitive pressure on incumbent equipment vendors to upgrade their existing equipment. And massive restructurings throughout the industry have eliminated billions of research and development dollars, which will further slow the pace of technical innovation.

Dilution Worries. With communication-equipment vendors experiencing negative cash flows and weak balance sheets, any major acquisition would probably be an all-stock deal. Many established vendors are trading below their enterprise value (market cap plus long-term debt, minus cash and equivalents) and probably feel that their current share price doesn't adequately reflect their long-term growth prospects. As such, these vendors will likely require a premium acquisition offer -- meaning that the potential acquirer will need to offer heaps of their depressed shares.

Unlike prior years, when stock prices acted as inflated currency, the current low share prices would significantly dilute the acquirer's share base. A large number of shares outstanding would make it much more difficult for a company to achieve earnings leverage when the industry begins to recover.

Fitting the Parts. Perhaps the most important factor holding back M&A activity is that integrating an acquired company during this weak operating market would require considerable management attention. Today, efficiency and execution have become the key variables for success. With many equipment vendors posting huge operating losses, investors are demanding that management place all their focus on reducing costs and returning to profitability. Companies are initiating aggressive restructuring programs -- including layoffs, plant consolidations, and the sale of noncore assets -- to streamline operations.

Undoubtedly, any major acquisition would add thousands of employees to an acquirer's expense structure at a time when cost-cutting is needed. Management would need to deal with integration issues such as product overlap and consolidating sales forces. During this industry downturn, management's prime focus should be on evaluating internal company operations and restoring core growth over integrating an acquisition for external growth. Investors would likely turn thumbs-down on major acquisitions, thinking that any company bold enough to do so would probably be biting off more than it could chew.

S&P expects the telecom-equipment industry to go through a gradual consolidation process, with M&A activity heating up when telecom spending begins to recover. So, investors who've gone bottom-fishing in hope that these depressed equipment stocks will quickly get taken out for a premium may be holding on to their lines longer than expected.

TWO PICKS. Despite the downturn in telecom spending, the communications-equipment sector remains an enormous market, with many attractive opportunities. Two of our favorite stocks are UTStarcom (UTSI) and Qualcomm (QCOM), both of which carry S&P investment rankings of 4 STARS (accumulate).

UTSI should continue to benefit from rapid growth in China's communications market, driven by the government's commitment to developing a communications infrastructure. Qualcomm is best positioned to benefit from the inevitable transition to broadband wireless networks, as its patented CDMA technology has become the technology of choice for third-generation networks. Analyst Bensinger covers telecommunications equipment stocks for Standard & Poor's


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