By Olga Kharif Over the past three months, telecom-equipment stocks have rallied faster than most other market sectors, rising about 24%, according to mutual-fund tracker Lipper. Most of the several dozen companies in the group are trading at an historically high 27 to 29 times projected 2004 earnings. But while the industry has morphed from Typhoid Mary to Sexy Sadie, Wall Street's love affair with it could be short-lived.
Chances are that investors have once again gotten ahead of themselves. In fact, many makers of phone-company gear are still struggling with high debt and are bleeding red ink. And while the industry is almost certainly nearing the bottom of a sickeningly steep slide, its recovery is likely to be mild at best: As recently as 2000, phone carriers spent 36% of their revenue on capital purchases. That figure has since plummeted to 12% and is projected to nudge up only to 14% by 2005, according to telecom consultancy RHK.
The gap between this stark reality and the share price run-up amounts to a big fat warning, analysts say. Investors typically want to get into stocks at the start of a rally, but "it's one thing to be early, and another thing to be too early," says Steve Levy, an analyst with Lehman Bros. And it can be particularly hard to distinguish between the two when some on Wall Street are continuing to blast hot air into the sector. In mid May, for instance, Salmon Smith Barney, former home of disgraced telecom analyst Jack Grubman, upgraded phone-gear maker Juniper Networks (JNPR) from inline to outperform. The stock has risen 14% since, to $14.85, making it vulnerable if the sector's current bubble bursts.
PARTY POOPERS? For investors who fear trouble, one sign to watch will be the guidance equipment outfits provide for the third quarter -- projections that analyst Paul Sagawa at Sanford Bernstein expects to be guarded at best. Companies such as Ericsson (ERICY), the world's largest wireless-equipment maker, could even suffer a sales decline in that quarter vs. the second, Sagawa believes. If he's right -- and if other suppliers offer the same outlook -- the eight-month party in share prices could fizzle.
There's also a longer-term reason to worry. Much of the world's wireless infrastructure is already built-out for now, and a new wave of orders could be a year away. Demand for regular phone equipment could remain slack for another year as well: Faced with declining revenues, the Baby Bells are keeping their purses clasped -- and it will be several years before they feel enough competition in their core phone business from cable companies to force them out of their capital spending lethargy, predicts Kate Horricks, a senior analyst at RHK. As a result, North American telecom capital spending will remain flat this year, at $31 billion, and won't start rising until late 2004 or early 2005, according to RHK.
That sounds inconsistent with some recent good news. At the end of May, three Baby Bells -- BellSouth (BLS), SBC Communications (SBC), and Verizon (VZ) -- announced that they'll jointly evaluate and buy equipment needed to string fiber to homes and offices in order to standardize their networks and take advantage of deeper discounts. But their purchases might not kick in until late 2004, analysts say. Moreover, the joint-buying arrangement could push down equipment prices even further.
LONG-TERM HANDICAP? One other element of support -- government spending -- could also arrive later than expected. Washington, which plans to build its own optical telecom network using Internet protocal (IP) routers, recently delayed awarding contracts valued at up to $900 million for the project's initial two years. Thus, the telecom-equipment industry won't see a revenue lift from that spending until early next year, instead of in late 2003 as originally expected, according to Lehman Bros.
The other vulnerability is that these stocks have risen faster than the industry's profits. Take Lucent Technologies (LU): Since 2001, it has cut its operating expenses by 75% and eliminated 67,500 jobs -- some 64% of its workforce. But while its stock has climbed 30%, to $2, over the past three months, Lucent has yet to return to profitability. And its now-slimmer product line could put it at a disadvantage to competitors, says Sam Greenholtz, a principal at consultancy Telecom Pragmatics in Westminster, Md.
In fact, many equipment makers have cut their research and development significantly, which could hurt their performance long-term, says Michael Mahoney, portfolio manager for a $100 million technology hedge fund at EGM Capital in San Francisco. Nortel Networks (NT), whose stock Mahoney holds, has slashed its R&D by 16%, to $489 million a quarter, over the past nine months.
STRONG BUT PRICEY. Take it all into account, and most mutual-fund portfolio managers are either dumping their shares in phone-equipment makers or restricting their investing to the few companies that are stable and profitable. For instance, many funds continue to hold shares of networking giant Cisco Systems (CSCO), which still sells mostly to corporations but is expected to grab a larger share of the phone-carrier market over the long haul. Cisco is also in a strong position to win some of the upcoming government contracts, believes Levy. However, its stock, which is trading at around $17.50, is pricey -- only 8% off the 52-week high it hit on June 19.
Alternatively, it might make sense to invest in companies in parts of the industry that seem likely to turn up first. Mahoney likes Adtran (ADTN), which supplies equipment to the broadband market. In fact, its core business in DSL gear is already expanding. Problem is, Adtran's stock is trading at $54.65, only 3% below its 52-week high of $56.25 in mid-June.
Many investment companies, such as EGM, also hold shares in Nortel, which has won a number of new contracts in the past several weeks. On June 25, it announced that it will provide equipment to No. 2 U.S. wireless provider Cingular Wireless. And Nortel is expected to post a profit this year for the first time since 2000. Its shares are trading at $2.95, down 17% from the 52-week high they hit at the beginning of June, thus creating what could be a buying opportunity.
A TURNING TIDE? Other portfolio managers, including Reza Samahin, co-manager of the Altamira Science & Technology and E-business funds, favor Lucent. At the end of May, it floated $1.525 billion in convertible bonds. Samahin says that strengthened Lucent's capital structure, which has been a primary worry for investors. Still, he suggests that investors not buy the stock until it falls below its current price of $2.
Of course, some experts still regard telecom-gear makers and their stocks as too risky. "I'm not sure that at any price we'd hold any of these stocks," says Peter Hofspra, senior investment analyst at the $113 million AIC Diversified Science & Technology fund, which does own shares of Cisco. "There's no history of management that has proven it can run a business."
Others feel a bit more optimistic. For the equipment makers, business "from here on will just get better," says Jeff Kagan, an independent telecom analyst. "There might not be a dramatic upturn in orders, but the tide is turning. It's just a matter of time before it lifts all ships." He agrees, however, that the coming upturn's strength may not justify the run-up in telecom-equipment stocks so far. Which means the industry may once again take its revenge on investors who imagined a future that seemed almost too good to be true. Kharif covers technology for BusinessWeek Online from Portland, Ore.