Taking Stock: Oversupply And Competition Keep Telecom Equipment Stocks Down

Investing in networking stocks has become like taking a ride on the Giant Dipper on the Santa Cruz Beach Boardwalk. The builder of the classic roller coaster envisioned that it would be a "combination earthquake, balloon ascension, and aeroplane drop." As a Californian, I'm always wary of earthquakes, but the more interesting questions is, when does the airplane stop descending?

Networking stocks were some of the hottest commodities during the tech bubble. At the peak, Cisco Systems was the world's largest company in terms of market capitalization, with Lucent Technologies and Nortel Networks not far behind. This, in turn, fed a whole component industry that drove up the valuations of semiconductor companies, such as AMCC, PMC Sierra, Triquint, and Vitesse, and optical component firms, such as Corning and JDS Uniphase, to unfathomable heights.

The massive build-out of telecommunications networks in the United States and Europe provided fuel for the bubble. Overbuilding eventually sent every company related to the telecom build-out into a tailspin. Though demand appears to have stopped declining, the return of growth remains elusive.

Demand for communication semiconductors, optical components, and telecom equipment doesn't occur in a vacuum. It's capital spending by telecommunications companies such as AT&T, Qwest Communications International, SBC Communications, Verizon, WorldCom and the like that drives demand.

As the bandwidth glut became apparent last year, these companies slashed capital expenditures in 2001 by 25% relative to the prior year. Anyone who has followed this industry knows that spending on telecom equipment is very cyclical, though the cycles are often so long that one almost forgets that.

For telecom equipment demand to return, demand for telecom services must return. Perhaps more important, the telecom carriers must have the financial wherewithal to increase spending.

While demand for voice and data services remains weak, local and long-distance services are facing increased competition from wireless. The wireless penetration rate is now around 46% in the United States and even higher in most of Europe, and mobile users are increasingly using their cell phones for local and long-distance calls. It's not helping that wireless providers are giving away more and more free minutes. However, growth in the number of wireless subscribers has dropped to a 12% to 14% rate this year from more than 25% in 2001. Any economic recovery, though, should increase demand for telecommunications services.

The prospects for a return to growth in the telecom equipment market aren't very rosy. A number of the telecom companies issued too much debt in the last couple of years. Qwest, for instance, now owes more than $24 billion. Its capacity to borrow more has been severely restricted.

Qwest isn't unique. Weakening fundamentals, debt downgrades, and several government inquiries into accounting at Qwest and WorldCom have increased the cost of borrowing or forced the companies to put up collateral to obtain the financing they want. To reduce the need for additional capital, spending on networks has been on the chopping block. This year, capital expenses may drop 20% or more.

Demand for wireless services was supposed to be a stronghold. But Nokia recently said that it forecasts weaker-than-expected sales of wireless telecom equipment, declining 25% year over year in the first quarter. Given Nokia's relatively strong position in the market, this doesn't bode well for the lesser competitors. Lucent, which has struggled with its own restructuring, lowered its forecast from 10% to 15% revenue growth to modest to 10% growth.

None of this points to an immediate turnaround in spending on telecom equipment or components. For now, I continue to wait patiently for that reassuring clicking sound as the Giant Dipper starts its ascent.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at [email protected].

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