Optical/IP Networks

Carrier Stocks Get An Upgrade

CIBC World Markets service provider analyst Tim Horan upgraded four incumbent long distance carriers today, signaling that at least a few providers have already hit bottom.

The move was just one of several positive factors contributing to a bullish day in the optical networking sector. The technology sector led a powerful rally on Wall Street and the Light Reading Index rose 12.98 (9.62%) to 147.92, yielding one of its best days in a long time.

JDSU executives provided some positive news when they hinted heavily that business was stabilizing (see JDSU Sees Stability). CIBC's Horan, meanwhile, turned suddenly more bullish on the beleagured carrier sector. “We believe we are early on the fundamental call, and this quarter’s results will look fairly miserable. However, we expect this will be the bottom, and return on invested capital (ROIC) and free cash flow will continue to improve sequentially at a steady pace, in our opinion, ” writes Horan in his report.

In the note, AT&T Corp. (NYSE: T) was upgraded to a "Strong Buy" from "Buy" with a $25 price target; Qwest Communications International Corp. (NYSE: Q) was upgraded from a "Hold" to a "Buy" with a $24 price target; Sprint Corp. (NYSE: FON) from a "Buy" to a "Strong Buy" with a $28 price target and WorldCom Inc. (Nasdaq: WCOM) from a "Hold" to a "Strong Buy" with a target of $18.

The powerful rally in the market helped push these companies closer to their targets today. AT&T finished trading at $17.01 up 0.41 (2.47%); Qwest was trading at $20.03 up 1.03 (5.42%); Sprint was at $21.20, up 0.45 (2.17%), and Worldcom was trading at $13.81, up 1.43 (11.55%).

These upgrades and Horan’s outlook for Bell operating companies like SBC Communications Inc. (NYSE: SBC) and Verizon Communications Inc. (NYSE: VZ) highlight the growing sentiment that incumbent players will emerge as the winners in the service provider shakeout.

What has happened to make this sector and these companies more appealing now? There are a variety of factors at play, but Horan sees consolidation, which will lead to fewer players with better pricing, as the main driver.

The long-distance market is overcrowded with new entrants who have been desperately lowering prices to gain market share and building out networks to extend footprint, says the report. Now that investors’ deep pockets are empty, many providers will either go out of business or will be bought by other providers. Already over 20 companies have declared bankruptcy in the past 12 months, and that trend is expected to continue.

Those that survive will likely combine with other service providers, Horan predicts. RBOCs, now targeting business customers, are likely to be the acquirers. For example, Verizon, which is trying to break into the long distance market in Pennsylvania, could benefit from buying other providers like Worldcom or Sprint.

As a result, he expects pricing in the long distance market to improve. He says that pricing has already started to stabilize in voice, and pricing for data will also stabilize as growth in supply slows and demand ramps up.

So what does this mean for equipment companies? The message is mixed. On the one hand, consolidation can hurt equipment providers, but on the other, a healthier carrier market is better for these companies in the long run.

“It’s not a negative for the equipment guys,” says Rick Schafer, an analyst with CIBC covering optical long haul equipment. “But it’s only slightly positive for them. It’s really more neutral. We’ve been saying for a while that there are too many long haul carriers. It’s great to start picking the winners, but it will be a while before this will affect them.”

Consolidation has a number of effects on equipment companies. For one, it means fewer players, which narrows the potential customer base for equipment vendors.

Companies going out of business reduce the number of potential customers for equipment companies to sell to, but it also creates a flood of equipment and assets out on the market. Current providers can look to "going-out-of-business” auctions to gain extra fiber routes and infrastructure equipment much cheaper than getting it from an original source.

Also, long distance providers are expected to continue cutting capital spending (capex).

“The key to solid overall industry fundamentals is less capex spending,” writes Horan. “Incumbents are being more highly valued by the markets for producing free cash flow, not profitless growth.”

Horan explains that capex spending has been way out of proportion for the industry. For example, in 2000, capex spending in the entire communications sector was $117 billion, or 45% of total revenues of $264 billion. He says that it’s inevitable that capex would settle back to an industry norm of below 25% of revenue. The trend seems to have already begun, with spending declining to an estimated $105 billion this year (down 10% year-over-year), and $90 billion next year (down 15% year-over-year), according to Horan’s report. He expects a decline to about $85 billion in 2003, driven by industry consolidation.

In the short term this is bad news for equipment providers. But in the long run, a healthier customer base is important. Equipment providers supplying these key long distance carriers could be the best positioned. For example, Ciena Corp. (Nasdaq: CIEN) is an important supplier to Qwest and Sprint. The company is also expected to ramp up sales with AT&T, according to CIBC’s Schafer. In a note he published earlier this summer, Schafer says he expects AT&T to start buying and deploying Ciena’s Core Director.

Large equipment houses like Tellabs Inc. (Nasdaq: TLAB; Frankfurt: BTLA), Nortel Networks Corp. (NYSE/Toronto: NT) and Lucent Technologies Inc. (NYSE: LU) could also ultimately benefit when these carriers get back on their feet. But Schafer warns that Nortel still has some major work to do before it’s finished. On the flip side, companies like Sycamore Networks Inc. (Nasdaq: SCMR), which has little exposure to these carriers, might struggle for strong customers.

“It will be good for equipment companies to have exposure to these carriers,” says Schafer, “but we’re getting to a point where what counts to investors is cash and earnings.”

— Marguerite Reardon, Senior Editor, Light Reading

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