Wrong Numbers for Telecom-Gear Makers


Investors can look at the partially filled glass on the cover of Ciena Corp.'s latest annual report in two ways. "We see opportunity," the document blares. And, in fact, Wall Street lately has started to view the glass as half-full for Ciena and its peers. Since Nov. 1, the stocks of most telecom-equipment companies have risen by 30% to 50%, while the tech-laden Nasdaq 100 has fallen by 6%. Ciena's (CIEN) stock has shot up 46%, to around $6.40, while rival Lucent Technologies (LU) has rallied 74%, to almost $2, and shares of Nortel Networks (NT) have jumped 111%, to around $2.60.

Of course, anyone who invested in the telecom-equipment sector prior to last year would call the glass half-empty, considering that over the past two years the stocks in that business have lost as much as 90% of their value as companies struggled through double-digit annual sales declines. Ciena's shares, even with their recent jump, now trade at 54% below their 52-week high of $13.97 a year ago.

Of the two perspectives, half-empty might be the wisest one for investors to embrace right now.

SUMMER BOTTOM? Not that the business doesn't show signs of life. On Jan. 23, Merrill Lynch raised its rating on most companies in the industry from neutral to buy, while UBS Warburg upgraded its stance from reduce to neutral. For many suppliers, December was better than expected. Their losses narrowed vs. 2001, thanks to relentless cost-cutting.

And though orders didn't rise, they at least stopped falling off a cliff, as major phone companies announced 2003 capital-spending budgets that focus, in large part, on equipment -- and that are down only 15%, vs. 2002's 30% drop. On Jan. 29, the biggest buyer of phone equipment, Verizon (VZ), announced that it plans to spend $12.5 billion to $13.5 billion on capital projects in 2003, vs. $13.1 billion in 2002 -- which was a 23% decline from 2001. Many more announcements like that, and equipment makers' sales could bottom out by summer, says Nikos Theodosopoulos, an analyst with UBS Warburg.

Wall Street's optimism has just one problem: Revenue growth for the phone companies -- the telecom-equipment industry's main customers -- is somewhere between slow and nonexistent. Verizon's fourth-quarter sales rose just 1.2%, to $17.2 billion, and that's positively sparkling compared with those of both BellSouth (BLS) and SBC Communications (SBC), where revenues declined 6.8% and 5.8%, respectively, in the fourth quarter and could dip again this year. If the past three years have proven anything, it's this: When the end buyer doesn't thrive, its suppliers don't, either.

BUMPIER RIDE. Jump-starting growth could take several years -- as could the turnaround for equipment suppliers. "Telecom spending is still in a nuclear ice box," says John Ryan, principal and chief analyst at telecom consultancy RHK. In 2003, overall phone-industry capital spending should fall by 15% more, estimates Steve Levy, an analyst with Lehman Brothers. Spending will then remain flat through 2005, some analysts think. If that happens, equipment makers will grow only by boosting their market share -- which implies more fierce price competition and perhaps an even bumpier ride for the industry and investors, says Shep Perkins, who manages $768 million in assets for Fidelity Investments.

Some bulls argue that grabbing telecom-gear stocks now makes sense anyway because they're undervalued. But after the latest rally, most of the sector's names are now fully valued or overvalued, says Levy. At $9.18, Juniper Networks (JNPR) has a price-to-sales ratio of nearly 6, while at a much more prosperous Intel (INTC), the ratio stands at 4, and for Microsoft (MSFT) it's 8.5. Investors who venture into the sector should be prepared to lose their shirts, says Michael Mahoney, senior portfolio manager at San Francisco-based EGMCapital funds. "There's the risk of a 50% downside and potential for a 200% upside," he says. "It's not for the faint of heart."

The downside risk will rise if the economy doesn't improve. In that

case, analysts say, phone companies could cut their capital budgets again by midyear. Some carriers aren't waiting. On Jan. 28, No. 3 U.S. wireless

operator AT&T Wireless (AWE) announced a capital budget of $3 billion in 2003, down 38.5% from last year, as it adjusted its growth projection for the year to mid-single digits, vs. high double-digit growth in 2000. For phone carriers, estimates for equipment spending in 2003 as a percentage of revenue have dropped to 10% to 15%, vs. 27% in 2002, says Raj Dave, a credit analyst with investment bank Commerzbank Securities.

SOFTWARE AND SERVICES. With revenues flat, carriers increasingly are trying to make what they already have go further. They might move an underutilized piece of equipment to a part of the network that's overloaded, says Ryan. And they're buying new gear only when their networks need fixing. That's why companies like Lucent have pared their product portfolios to the basics: mainly, parts needed for maintenance and repairs.

When the phone companies do open their wallets, moreover, they'll likely

spend more of it than in the past on software and services vs. hardware. In 2000, some 54% of capital spending went to equipment, vs. 43% today, estimates Levy. Better billing software seems to be a hot seller at the moment. Thus, gearmakers such as Lucent and Alcatel (ALA) are making a major push into software and services -- where they face formidable competition from the likes of IBM (IBM) (see BW Online, 12/19/02, "Lucent Looks Longingly at Services").

Price competition between phone carriers could increase as well -- and

adversely affect equipment suppliers. Within the next six months, the

courts will settle on a bankruptcy reorganization plan for WorldCom (WCOEQ). If it's relieved of much of its debt burden, other carriers could end up at a disadvantage, says Richard Thayer, president and CEO of consultancy Telecommunications & Technologies International in Bethesda, Md. That could hurt spending on phone gear and even prompt consolidation -- which already seems in the cards for wireless providers.

FEW ALTERNATIVES. Quick fixes for these trends are hard to find. The Federal Communications Commission could decide in mid-February that the Bell companies can charge local competitors more for the use of the Bells' networks (see BW Online, 11/19/02, "A Nationwide Brawl over Local Phones"). Yet at most, the Bells could reap an additional $2 billion in annual revenue from such a change, estimates Andrei Jezierski, a founder of Internet infrastructure consultancy i2 Partners in New York. That would be peanuts for a $150 billion industry.

Carriers are also experimenting with new services, such as high-speed wireless Internet access, to prop up revenues, but that will take time. Some gearmakers hope to garner some growth from developing markets in India and China. Yet European suppliers such as France's Alcatel, which already has a strong presence in the region, might benefit from that more than North American companies.

For investors intent on getting into the sector now, some options are safer than others. EGM's Maloney holds Nortel, primarily because its price is still so low compared to prior years -- and because he believes that news on the economy will get better rather than worse. Still, he says he might sell the stock and buy it back several times in the coming months to lessen his risk. Investors who aren't prepared to play that game might remind themselves that even when a glass looks half-full, it could really be half-empty. By Olga Kharif in Portland, Ore.


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