Optical/IP Networks

Report Downgrades Cisco and Nortel

Sanford C. Bernstein & Co. Inc. analysts Paul Sagawa and Vadim Zlotnikov published a report this morning on service provider capital spending. And the news isn't good for equipment vendors (see Optical Stocks Hit by Rumor).

Having surveyed some 59 carriers, the investment firm's report concludes that capital spending will decelerate drastically over the next year -- dropping from 28 percent growth in 2000 to less than 20 percent in 2001. And it seems that no part of the networking industry will be left unscathed.

“The effects of deceleration will be felt in all categories of spending, including the high growth optical, data and wireless sectors,” says the report.

Specifically, Sagawa and Zlotnikov downgrade Ericsson AB (Nasdaq: ERICY) to an “under perform” rating, and Cisco Systems Inc. (Nasdaq: CSCO) and Nortel Networks Corp. (NYSE/Toronto: NT) both to “market perform” -- down from “out perform” ratings.

According to the report, this could be Cisco’s ninth and final consecutive quarter of year-over-year growth. Growth rates are expected to decline from a high of 63 percent back to Cisco’s traditional range of 30 to 50 percent growth, says the report.

Why? One reason cited is that even though 30 percent of Cisco’s revenue comes from service providers, that amount also accounts for 80 percent of its growth. That means that if carrier spending slows down, so will Cisco’s growth.

The second reason is that in the last quarter products from the Cerent, Aironet, and ArrowPoint acquisitions have all contributed at least 10 percent of revenue and 61 percent of the company’s growth. But as these markets mature the growth will slow down.

“Furthermore, recent acquisitions do not appear to offer the same immediate upside delivered by these three home runs,” states the report.

The third reason is that Cisco is facing more competition in key growth areas -- especially the high-speed IP router market where Juniper Networks Inc. (Nasdaq: JNPR) has managed to steal roughly 17 percent market share in 18 months.

The news is just as bad for Nortel, which has also been downgraded. Essentially, Sagawa and Zlotnikov are skeptical that Nortel will be able to sustain its 40 percent growth rate. Even though the next two quarters are predicted to remain strong, as carriers finish out their spending budgets for 2000, revenue growth is expected to tank to less than 30 percent in 2001.

“Nortel’s stronghold optical business is unlikely to be spared from sharply reduced spending by the new build carriers that have fueled its two-year rise from the ashes,” says the report.

The only slightly positive suggestion for optical investors to come out of this report is to hold onto shares of Lucent Technologies Inc. (NYSE: LU). Why? The company is so far in the hole that it couldn’t hurt to hang in there, the analysts say.

“We believe that companies that have already been beaten up (LU, MOT, COMS) and companies that focus on consumer devices that do not depend on carrier spending (PALM, NOK) represent the best harbors in what could be a harsh communications equipment market.”

But not everyone on Wall Street shares Sanford Bernstein’s apocalyptic outlook. Paul Johnson, senior technology analyst for Robertson Stephens says this is all “total, total nonsense.” He disagrees whole-heartedly with the Sanford Bernstein report on two counts. For one, he says that over the past several years carriers have notoriously underestimated capital spending.

“Carriers have been terrible at forecasting,” says Johnson. “If you’re wrong eight times out of 10, why would you listen anymore? And now some are suggesting that these estimates are gospel.”

The second reason he doesn’t believe the report holds water is because the carrier market has shifted greatly over the last three years. Increased competition has forced service providers to buy next-generation equipment that will help them deploy new revenue-generating services.

“I’m sure carriers would like to slow capital spending,” says Johnson. “But there is nothing they can do about it. If they slow down, they go out of business.”

Wall Street as a whole doesn’t seem to be swallowing the doom and gloom expectations, either. At midday trading Cisco was only slightly down -- less than a percent -- and Nortel and Lucent were both up, about 5 percent and 9 percent respectively. Other optical players are also on the rebound from yesterday’s rumor shakeup. JDS Uniphase Inc. (Nasdaq: JDSU), Juniper, and ADC Telecom (Nasdaq: ADCT) were all up today in midday trading. But some optical stocks are still taking a hit. Sycamore Networks Inc. (Nasdaq: SCMR), ONI Systems Inc. (Nasdaq: ONIS), and Corvis Corp. (Nasdaq: CORV) are all still down, from 1 percent (Sycamore) to nearly 7 percent (Corvis).

“This is a healthy debate to have,” says Johnson. “But I just can’t imagine that Armageddon is coming.”

-- Marguerite Reardon, senior editor, Light Reading, http://www.lightreading.com

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