Capex is King
After we published a recent news story on the prospects for a capital spending (capex) rebound in 2004, a reader wrote on the LR message board that "capex is a useless generalization" (see Packets Key to Capex Comeback and Carrier Capex Set for 2004 Rebound).
In fact, said reader went even further, pronouncing: "The moral of this story is, overall CAPEX is a worthless metric unless you are a macroeconomist."
Um, okay. What a lunatic!
You may think that capex is a worthless metric. That is, unless you care about profits, growth, jobs, and the health of an industry at large.
Capex is, in fact, the most reliable metric available. The telecom industry saw its bubble grow, and burst, firmly on the back of a capital spending binge. People made bad decisions based on the fact that bubble-type growth could continue for years.
So does capex matter? Let's look at it this way: It's billions of dollars that are either spent or lost. For the carriers, it's how they are betting on their future. For the equipment providers, it's where they'll get the money.
Capital spending is typically a cyclical affair, with carriers ramping up to build out new networks when the previous generation starts aging. Typically this cycle falls about every 10 years. The only trouble with the cycle in the late 90s was that it spun out of control. And by measuring how much capital was being spent, one could conclude that the carriers were spending at an unsustainable pace.
The most useful metric for the sustainability of capital spending over time has proven to be the capex/sales ratio of the major telecom carriers. Our paid research service, Light Reading Insider has tracked this indicator over time and revealed in 2001 that the capex/sales ratio had spiked to more than 50 percent of carrier sales.
As a freelancer we recently hired to look over these numbers recently remarked, "That seems impossible!"
Yes, it does. How would a company survive spending more than half of its revenue on capital equipment? It doesn't make sense until you consider the investment climate of early 2000, when folks were virtually throwing money at anything that even smelled like "telecom." Most carriers were able to sustain such a dangerous business move by taking on more debt and raising capital through the sale of shares and IPOs.
If you thought this was irrational, the capex/sales ratio didn't lie. For the top carriers tracked by Light Reading Insider, it rose from a historical norm of about 15 percent to a peak of nearly 80 percent in 2000. Light Reading Insider, then known by the moniker "Optical Oracle*," concluded at the time that this ratio was likely to revert to the historical norm and that it was due for a multiyear decline (see Optical Oracle: More Carrier Cutbacks ).
What's happened since? Not to toot our own horn, but it's declined, steadily, back toward the norm of 15 percent. The bean counters like to refer to this kind of activity as "reversion to the mean."
So what's next? Well, according to our research, the capex/sales ratio for the "Big Six" carrier that we tracked most recently had dipped to 13 percent. For some carriers, it's fallen as low as 10 percent. That's actually at, or even slightly below, the historical norm.
In other words, the pendulum may be swinging too far in the other direction. The thing is, carriers can't cut much more. It's virtually impossible for them to spend less than 10 percent of their revenues on capex, because they have minimum requirements for network maintenance. To boot, some of their equipment, specifically Sonet/SDH gear, is starting to show its age. In fact, there's evidence in the last few quarters that carriers are dipping their toes back into the water -- with many of the largest, including SBC Communications Inc. (NYSE: SBC) and Verizon Communications Inc. (NYSE: VZ), logging three consecutive quarters of increasing capex.
There is one catch to this theory: Industry revenues over time could continue to decline. In this case, the ratio of capex/sales could remain the same, but because revenues are actually shrinking, capital spending would continue to decline.
This seems doubtful to me. Telecom revenues have been climbing for more than 100 years, and the recent recession is only a brief pause. What's more likely is that capex will shift to more important technology that can drive the development of new packet-based services. It should then remain fairly constant, at about 15 percent of revenues, and grow as the industry grows.
As for those who think capex analysis is bunk: Listen up. It's telling you more than you think.
— R. Scott Raynovich, US Editor, Light Reading
* Absolutely not associated in any way with Oracle Corporation.