Markets & Finance

Playing Telecom's Shakeup


Communications equipment stocks, already the best-performing information-technology sub-industry this year, got a bigger boost on Mar. 24 from the announcement from major players Alcatel (ALA) and Lucent (LU) that they're in discussions to merge. "In our opinion, consolidation is long overdue in a communications equipment market oversaturated with a plethora of vendors," says Ari Bensinger, who follows the group for Standard & Poor's Equity Research.

Ken Leon, Bensinger's colleague at S&P, kept his recommendations of hold on Alcatel and sell on Lucent on the news. "The news does not change our view that Lucent and Nortel (NT) are most vulnerable to customer consolidation," Leon says. "With high sales concentrations from a few customers in the fixed and wireless carrier markets, Lucent might create cost savings in a merger with Alcatel, but that would not change the end user market."

Bensinger has a neutral fundamental outlook on communications equipment makers, and forecasts modest mid-single-digit industry growth and carrier spending this year. The planned merger between AT&T (T) and BellSouth (BLS) could hamper spending on equipment in the short term, Bensinger says, but over the long haul it's clear that telecom operators are committed to upgrading their networks to offer the next-generation of services. His favorite stock in the group is Cisco Systems (CSCO), which he ranks as buy.

BusinessWeek Online's Karyn McCormack recently spoke with Bensinger about the AT&T-BellSouth merger, and about stocks to buy and avoid. Edited excerpts of 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.

How will consolidation affect communications equipment makers?

In the near term, we believe the proposed merger between AT&T and BellSouth could reduce capital spending, because the combined company will likely assesses how to streamline its network and overcome integration challenges (see BW Online, 3/8/06, "Static from a Telecom Tie-Up").

We also expect the new company eventually to merge equipment suppliers to increase buying power. There's some opportunity for equipment suppliers that are well entrenched with AT&T to replace current BellSouth suppliers.

In the longer term, however, the impact should be minimal. In fact, AT&T stated that out of the billions of dollars of targeted synergies for 2007, only $200 million relate to capital expenditure savings, which in our view underscores the strong commitment by carriers to migrate to next-generation equipment.

What's your favorite stock in the group?

We believe Cisco Systems is well positioned to benefit as content traffic increasingly migrates from classic voice equipment to the Internet's infrastructure equipment. With Cisco's broad product portfolio, it should benefit from an industry trend toward integrated routing and switching products.

We view the company's business model as attractive, with gross and operating margins of roughly 70% and 30%, respectively, some of the best in the industry. Additional positives include a strong balance sheet, with $15 billion in cash and cash flow generation at an average clip of $600 million per month. We have a buy opinion and a 12-month target price of $23 on the stock.

Are there any stocks investors should avoid?

We have a sell opinion on Avaya (AV). While we believe it is well positioned to benefit from a current transition to Internet telephony, we expect overall revenue growth to be hampered by a continued material decline in legacy telecom product sales and intensifying competition.

Currently, cost cutting initiatives are the primary driver of earnings growth. We do not expect the stock's valuation multiples to expand until the company begins to generate material revenue growth.

We also have a sell recommendation on JDS Uniphase (JDSU), largely because of valuation concerns. We also see operational challenges related to integrating the large acquisition of Acterna and executing its aggressive restructuring initiatives.

What's the major growth driver for the group?

From a strategic perspective, in an effort to offset continued erosion in voice revenue, telecom operators view the creation of new bundled services as a top priority (see BW Online, 1/27/06, "Communications Gear's Strong Signals"). We regard network equipment upgrades that help transport data, voice, and video more efficiently as the key to creating new applications that restore growth in the telecom service market.

Moreover, the competitive environment has intensified, with cable operators targeting high-speed Internet subscribers and entering the voice arena, leaving little choice for the telecom carriers but to spend on equipment upgrades that can enable full-service offerings.


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