A telecom-equipment recovery?

HEADNOTE

INDUSTRY REPORT

HEADNOTE

Though the telecommunications boom has waned, the significant amount of capital already invested in infrastructure will help fuel the coming surge.

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LOOKING for a silver lining in the cloud hovering over the telecommunications-equipment industry can take a little comfort in the prognosis that the worst seems to be in the past. That's not to say that the near-term future is particularly bright, but from the bottom of the valley, just about any news seems positive.

Gone are the heady days of 2000 and the late 1990s, when telecom equipment enjoyed positively explosive growth and few saw an end in sight. For a variety of reasons, the industry crammed about a decade's worth of growth into three years, which was great while it lasted but devastating when the bubble burst.

Today, more than a quarter million people are out of work, stocks are depressed, sales are in the dumps, and big plans for manufacturing expansion are faded memories. Observes Nikos Theodosopoulos, a telecom-equipment analyst for UBS Warburg, "The telecom industry has experienced a boom-- to-bust cycle in the past two years."

What Went Wrong

The problems in the telecom-equipment industry are directly related to the severe woes facing telecom carriers - from large long-distance companies to local phone companies to upstart communications providers. "What's happening is that telecom carriers the purchasers of telecom equipment - overbuilt their networks for a whole bunch of reasons," says Steven Levy, global head of communication-technology research for Lehman Brothers.

That overbuilding caused impressive, if brief, growth in the sale of telecom equipment. Capital spending by carriers grew by more than 30 percent to $50 billion in 2000 - representing some 35 percent of their total sales.

But the good news didn't last. One of the first industry observers to raise a red flag was Paul Sagawa of Sanford Bernstein, who warned in early 2001 of "an orgy of overinvestment plus intense price competition."

"At the beginning of 2001, carriers started to cut back on their spending," Levy says. "That cutting-back process accelerated toward the end of the year.

The telecom-carrier story is not unlike the tale of the dot.coms, which saw similar explosive growth followed by a painful crash at about the same time. Not only was the schedule similar; so were the causes.

"The root of the problem obviously is that carriers were spending more than they were generating in revenue. That's a business model that's not sustainable," says Ari Bensinger, a telecom and communications-equipment analyst for Standard & Poor's. "That happened over the three years before 2001. The market ignored this fact and was willing to provide an enormous amount of capital to the service providers even before they saw the outcome of their investment. Finally, in 2001, that capital dried up and carriers' stocks were negative, and they had to stop spending in order to generate cash."

Levy says the telecom gold rush had its roots in the Telecommunications Act of 1996. "It effectively opened up competition and deregulated competition to an extent that we've never seen before," he says. "We went from hundreds of service providers to thousands of service providers. It was a wonderful thing for a few years, but the majority of them had flawed business models."

One of the key flaws was a gross overestimation of how fast demand for bandwidth would grow. The Internet economy was on everyone's minds, and who didn't want better, faster, and more powerful communications services? "Everybody thought bandwidth was going to grow over 100 percent a year," Bensinger says, and carriers built their networks with that kind of growth in mind.

In reality, the growth rate was more like half of what prognosticators expected. Industry-watcher Economy.com notes that wholesale prices for long-haul bandwidth have been steadily falling. So have long-distance prices. "Voice is a commodity," Bensinger notes. "They need to get equipment that really changes them from voice to data networks. The problem is that they need to figure out how to generate money from data."

The wireless industry also spent the last few years of the 1990s and the year 2000 investing heavily in infrastructure and capacity. As Economy.com notes, such investments are not without a logical foundation; after all, market penetration in the wireless industry is still less than 50 percent in the United States, even as it nears two thirds in Europe. Still, it appears that wireless growth projections may have been a bit too optimistic, and cell-phone makers had to cut their projections in 2001 as well.

Overly rosy predictions of demand also inspired real estate developers to create millions of square feet of socalled telecom "hotels" designed to house switching equipment and web servers. As it turned out, many of these hotels still have plenty of vacancies, with some less than half full.

When the Bubble Burst

The explosive growth in business through 2000 made the subsequent rapid evaporation of business all the more shocking to the telecom-equipment industry. "They're going from two extremes," Bensinger says. "A lot of these guys were doing billion-dollar expansions, but they were based on historical results and the historical results were out of whack."

In many cases, major facility plans were suddenly shelved. For example, in April 2000 fiberoptics maker Coming Inc. took over a factory in Scranton, Pa., and in December 2000 it unveiled plans for a $150 million expansion there that would bring 2,500 new jobs. For a brief few months, Coming was able to deliver some of those promised jobs, which the community badly needed. Around the same time, another fiber maker in Scranton called FiNet Technologies made plans to double the size of its plant.

But by the summer of 2001, the bottom had dropped out of Coming's business and the company decided to close the Scranton plant, which was only half finished. Some 600 workers lost their jobs. More were idled at FiNet, which had hired a few hundred during the boom but cut back to about 150.

"We're seeing large manufacturers selling off plants, closing plants, trying to right-size their operations," Levy says. "We've seen large business units being cleaved off of the large OEMs like Lucent and Nortel. As they slim down, we've seen 275,000 jobs cut in telecom equipment from a base of about 900,000" at the beginning of 2001. That employment peak at the start of 2001 was 100,000 greater than the figure from just six months earlier, he says.

Major layoffs have happened up and down the telecom-equipment food chain, says Bensinger. "They've cut their work forces 30 to 40 percent, and that's the norm for the industry." In fact, telecom job cuts represent as much as a fifth of -all jobs lost during the recent economic downturn.

Lucent Technologies, one of the industry's biggest players, offers a telling example of the impact of the downfall. A powerhouse in 2000, it has undergone a massive restructuring that has cost tens of thousands of workers their jobs. The company has narrowed its focus to select service-provider customers and streamlined operations as it tries to return to profitability. While its losses have narrowed impressively from the 10-digit range, the ink is still red.

As if losing boatloads of business wasn't bad enough, many telecom-- equipment makers had extended credit or loaned money to their customers, making these carriers' woes doubly distressing. And while many industries are able to weather hard times through consolidation, certain front-page headlines that have little to do with telecom equipment have left investors with no appetite for such deals. "What happened with Enron is a big negative for this industry," says Bensinger. "We haven't seen any deals."

Where Things Are Headed

"Going forward, the picture continues to be glum," Bensinger says. "Carriers' capital spending is expected to be down 20 percent in 2002. Service providers are doing anything they can to avoid capital spending. Compounding that issue is the fact that the networks are overbuilt."

That means that there's a lot of excess capacity to absorb before the buying resumes in a big way. "There's no reason for carriers to spend money for new equipment," Bensinger says.

"They need to eat into this excess capacity," Levy agrees. "When [the sector] does turn up, the end-user demand needs to be there, and that's economy-sensitive."

Still, Levy is able to put a somewhat positive spin on the future by looking a little further down the road. "I think we're near the end of the cutbacks. We've probably seen the vast majority," he says. "Our forecast is that in the fourth quarter of 2002 we'll start to see some small increases in spending, and in 2003 we'll see it move up about 5 percent. We will get back to a small amount of growth in 2003."

But don't look for a giddy recovery, Bensinger adds. "It's not going to be a V-shaped recovery. It will be canoe-- shaped. Growth will be in the mid-single-digits in 2003."

The whole boom-and-bust experience has left telecom-equipment makers and observers alike somewhat wary of offering solid predictions about the end of the telecom downturn. "It's hard to say when it will come back," Patricia Russo, the recently named CEO of Lucent, told CBS.Marketwatch.com in January. "There's no question the industry has been digesting the bubble that we saw in 1999 and 2000, when unsustainable levels of spending occurred. So there is some uncertainty as to when the industry will recover to its normal pace."

"The truth is, no one knows," Bensinger agrees. "Listen to any of their conference calls. Before, their forecasts were for the year. Now, the forecasts they're giving are not even for the next quarter."

Analyst Jay Ritter of Morningstar.com is able to spot some silver linings for telecom equipment. For example, while carrier spending is bleak, "things are not as gloomy on the corporate-networking front," he writes in a recent analyst report. "There are pockets of strength in industries like healthcare and defense." He concludes, 11 We're not ready to throw in the towel." And some observers also see the potential for upgrades in the nation's wireless networks as carriers strive to offer new services. That would require equipment purchases.

There's no question the telecom-- equipment industry will bounce back at some point. Just as the level of spending in 1999 and 2000 was unsustainable, not buying telecom equipment is also unsustainable in a modern world. As Russo told CBS.Marketwatch.com, "Notwithstanding the current condition, this industry will be reinvigorated. It's just a question of when."