The Capex Cloud

The collapse of the competitive local exchange (CLEC) market and the cuts in carrier capital spending (capex) caught everyone by surprise in late 2000 and early 2001 because it all happened so abruptly. As everybody now knows, equipment orders suddenly started shrinking at an alarming rate – and the effects were soon felt throughout the whole optical networking industry.

The big question now is when will things brighten up? Or at least even out? Will orders start flowing again before things take another turn for the worse? Will there be further rounds of belt tightening, further massive layoffs, and even more bankruptcies?

In an effort to address these questions, Optical Oracle, Light Reading's subscription-based research service, analyzed the spending plans of carriers a few months ago and published its results (see Optical Oracle: More Carrier Cutbacks ).

The following report summarizes some of the key findings of that time and brings things up to date with recent developments on the carrier spending front. It also looks forward to the big carriers' upcoming earnings announcements, where further spending adjustments for 2002 may be announced.

Here's a hyperlinked summary:

Page 2: Recent Developments

Page 3: What Happened

Page 4: More Cuts to Come

Page 5: When Will It End?

Editor's Note: Light Reading is not affiliated with Oracle Corporation.Since Optical Oracle's report on carrier capital spending at the beginning of November, much has happened, but little has changed.

In early November, Enron Corp. (NYSE: ENE) declared its once cherished broadband network to be a "non-core asset" – something that needed to be sold for pennies on the dollar and may take as long as a year to unload (see Enron's Empty Bandwidth). Enron's undoing came from factors above and beyond its broadband businesses, but it had pumped millions into optical equipment makers for gear and strategic investments. When Enron, in so many words, dismissed its telecommunications business as a waste of money and effort, a chill ran through the industry, as other carriers were still thinking up ways to wring revenues out of their investments.

About a month later, Qwest Communications International Inc. (NYSE: Q) cut its 2002 capital spending budget by more than a billion bucks and laid off 11 percent of its staff (see What's Behind Qwest's Numbers?). Though analysts say the company will continue to spend on data networking and IP gear, Qwest's cuts clearly took skin off the nose of a handful of optical transport gear makers, such as Ciena Corp. (Nasdaq: CIEN), Corvis Corp. (Nasdaq: CORV), and Nortel Networks Corp. (NYSE/Toronto: NT) (see Ciena Casts Cloud Over 2002 and Corvis Feels Qwest Fallout).

In December, Global Crossing Ltd. (NYSE: GX) said its creditors had granted it 45 days to come up with a way to pay off some $2.5 billion in loans (see What's Next for GX?). Characteristic of several carriers who built too much too quickly, Global Crossing had about $2.26 billion in cash and equivalents as of the three-month period ended September 30, but the company was also carrying $7.6 billion in long-term debt. The company said it expects to spend between $1 billion and $1.25 billion on capital equipment next year, down from the estimated $4.5 billion it spent in 2001.

Table 1: Historical Capex and Current Estimates, 1998-2002 ($Millions)

Editor's Note: Light Reading is not affiliated with Oracle Corporation.Several events came together in 2001 to spell the end of the capital spending frenzy of the preceding two years, when the major carriers on average were spending more than 100 percent of their sales on network expansions and racking up huge amounts of debt.

Table 2: Capex to Drop More Than 30% in 2002

One reason for the slowdown is that several carriers say they've finished key parts of their core networks and don't need to spend as much now. "We have good coverage, we have plenty of capacity in our network, so the only spending we're really doing now is to add customers to the network," says Thomas G. Osha, Broadwing Inc.'s (NYSE: BRW) chief of staff. "I think the spending the carriers will be doing in 2002 will be to get more bandwidth out of the networks they already have."

The carriers also have been using the broader economic slowdown as leverage against equipment vendors in order to get new, efficient networking technology at yesterday's prices. "They're squeezing the vendors to death, there's no doubt about that," says Patrick Comack, a telecom analyst at Guzman & Company.

"Our experience with mainstream carriers is that they're simple guys," White Rock Networks' CEO Lonnie Martin told Light Reading in December (see White Rock Expands). "They line up two or three reliable equipment providers that basically have the same product. Then they beat the hell out of those guys on price before they buy." ("Simple guys" in the Alley-Oop sense, apparently.)

Also, several of the carriers that added to the spending spike of the past few years – CoreExpress, Excite@Home, Exodus Communications Inc., PSInet Inc. (Nasdaq: PSIX), Star Telecom, Teligent, 360networks Inc. (Toronto: TSX), Viatel, WinStar Communications Inc., and many others – have filed for bankruptcy or closed and other carriers have picked up some of the stranded assets. (See Cisco's Under-Powered Carriers , Winstar Sues, Lucent Scoffs, Teligent Goes Chapter 11, 360networks Calls It Quits, Williams Acquires CoreExpress, and Cable & Wireless Takes On Exodus .)

But though carriers hit the brakes hard in 2001, their upcoming earnings announcements may show that there is still much more capex budget cutting to be done. Just as they used Internet growth to excuse huge network expansions in 1999 and 2000, they'll likely use this current period of slower growth to keep cutting spending and focusing on their balance sheets.

Also, the demand for telecom services has fallen off during the weak economy, creating more uncertainty for carriers in 2002 and more reasons for them to cut spending (see 2001 Top Ten: Services ). "The [service provider revenue] problem we hear most often is simply volume related – next to none for [network capacity] and sluggishness for usage based products," writes Merrill Lynch & Co. Inc. telecom analyst Adam Quinton in a recent note to clients.

That doesn't mean, of course, that carriers won't add new services and won't spend on any new equipment. But it does imply that there aren't likely to be as many advanced services – such as Sprint Corp.'s (NYSE: FON) defunct ION network, SBC Communications Inc.'s (NYSE: SBC) defunct Project Pronto, and Enron Broadband Services Inc.'s defunct video-on-demand deal with Blockbuster – announced in the next couple of years (see Whatever Happened to Sprint’s ION?, Energy and Optics: Dynamic Duo, and SBC: Uncle Sam Killed Broadband).

Even in a year of decrease in capex spending, there is still a necessity to invest in next-generation technology for broadband service deployment, says David Markowitz, Vice President of Marketing for Zhone Technologies Inc.

But, of course, competing in such an environment as a startup equipment vendor will be as tough as it's ever been. "Our advice to companies who want to play in this space is: Go raise half a billion dollars and make sure you're acquiring market share that generates revenue for you," says Markowitz (see Zhone Details Product Strategy and Mory Ejabat).

So what does the capital spending picture look like for 2002? Many analysts feel that historical spending data and the most recent available spending projections by carriers show that, on average, carrier spending will drop somewhere between 30 and 35 percent from 2001 levels. (A notable exception, however, is analyst Paul Sagawa of Sanford C. Bernstein & Co. Inc., who says capex won't be touched in 2002 – see Sagawa Calls a Bottom).

This will mean that the overall capex-to-revenue ratio will also drop for the foreseeable future. By and large, this is a good thing, because it means carriers won't be taking on more debt while they add to their networks, and they'll be less likely to go bankrupt or find themselves in a predicament similar to Global Crossing's. Individual carriers will report varying results, but the overall capex-to-revenue ratio – a leading indicator of when the telecom bubble first began to swell – will look more like it did in 1997 than the bubble years of 1999 and 2000.

Table 3: Capex-to-Revenue Ratios Decline

Carriers won't disclose network utilization information, which could be a strong indicator as to when they'll begin to buy more new network equipment, but earlier this year Optical Oracle reported that many carriers face unused capacity of 30 to 40 percent, while some see 70 percent of their bandwidth lying fallow (see Carriers at Risk).

Other indicators as to carrier health and spending potential comes from watching sales from database companies like Oracle Corp. (Nasdaq: ORCL) and server companies like Sun Microsystems Inc. (Nasdaq: SUNW), according to CIBC World Markets analyst Stephen Kamman: "When companies buy more applications and the databases to run them, they buy more servers. Adding servers to the network increases traffic, and that drives demand for enterprise network upgrades and more purchases from service providers." Kamman says that the deteriorating fundamentals in these sectors during late 2000 offered some warning for the networking and carrier spending downturn of 2001.

Several factors came together to slow carrier spending down, especially the abuse of vendor financing, competition by upstart carriers, and anxiety about component shortages that many feared would raise equipment prices (see Vendor Financing, CLEC Fear and Longing, and Components Shortage Delays Deliveries). Carriers won't see spending stabilize or increase until they use up some of their overbuilt network capacity, improve their balance sheets, and see a marked increase in enterprise spending. The industry may be some ways down that road already, but we won't know for sure how deep the cuts for 2002 will be until the carriers' earnings season begins.

Table 4: Carrier Earnings Calendar

Editor's Note: Light Reading is not affiliated with Oracle Corporation.