Sagawa Calls for Rebound (Again)
Sagawa earned credibility in the industry in late 2000 when he was the first to talk about a phenomenon called the "capital-spending slowdown," which led him to downgrade Nortel and Cisco (see Report Downgrades Cisco and Nortel ). At the time, he was ridiculed by other sell-side analysts for his cautious outlook (they were later proven miserably wrong).
Then, in early January of this year, Sagawa started hinting that the industry would pick up later in 2002 (see Sagawa Calls a Bottom). Now, he appears to be following his prediction up with stronger words.
"Everything we’ve been doing tends to point to this quarter as the inflection point," Sagawa says. He cautions, however, that this doesn’t mean that we’re on our way back to the spending patterns of the late 1990s.
At first glance, an anticipated 25-plus percent drop in capital expenditure (capex) this year compared to 2001 might not sound like great news, but Sagawa insists that the current quarter will represent a significant turning point in what he describes as a cyclical industry.
On a conference call this morning, Sagawa said that we can expect to see one of two scenarios play out over the next year: Either capex spending will increase, or budgets will be cut by an additional 5 percent. “I don’t think that will happen,” he said of the latter.
According to his research note, investment in communications equipment will start picking up in the second half of this year. This has to do with a tendency many companies have to play it safe in the beginning of the year and then start spending later on. Several other factors will also lead to increased spending, Sagawa said, such as the strong and increasing cash flow by incumbent carriers and deteriorating network performance. In 2003, the analyst predicts that spending will grow between 3 and 5 percent.
To reach these predictions, Bernstein closely followed 40 American and Canadian carriers over time. Sagawa says that this is the same technique that allowed the research company to make the famous downgrade of the telecom sector well before other analysts started to worry. The expected capex growth only concerns North America, however. "I think you’ll see spending down through the third quarter in Europe," Sagawa said.
For the year, spending by established incumbents is projected to decline by 23 percent, compared to a decrease in spending of about 70 percent by new carriers. Wire-line investments will drop by 33 percent, while spending on wireless networks will be up by 4 percent.
"My opinion is that most, if not all, of the alternative long-distance providers will not only go bankrupt, but will also be forced to liquidate,” said Sagawa. “There will be a lot of equipment rusting on the racks and a lot of fiber rusting in the ground.”
(The question of how, exactly, fiber could rust was not addressed.)
While this is not great news for the new kids on the block, this is probably the best thing that could happen for the more established players in the industry. With alternative providers falling by the wayside -- their equipment left in the trenches, usually too customized or too out of date to be sold -- and customer demand slowly returning, the established incumbents, which have reported improving cash flow for three consecutive quarters, can start raking in the contracts.
More good news for the survivors in this game, Sagawa says, is that the effect of overcapacity might be shorter lived than many have thought. “We think that there are clear signs that capacity is being absorbed,” he said, pointing out that Bernstein has heard that major long-haul networks are experiencing increased latency. He also said anecdotal evidence suggests that pricing for retail communications services has stabilized. He wouldn’t reveal where he’s getting this information from, however, for fear of being cut off from the source.
The overall winner in this turn of events, will, according to Sagawa, be Lucent Technologies Inc. (NYSE: LU). “Lucent is clearly the beneficiary of all the trends that I’ve described,” he said, observing that the company has a strong exposure to the healthiest carriers in the business.
Nortel Networks Corp. (NYSE/Toronto: NT) has also received an Outperform rating from Bernstein, although Sagawa says that, because it has more debt and a less developed wireless business, the company will probably take longer to recover. Cisco Systems Inc. (Nasdaq: CSCO), on the other hand, only received a Market Perform rating, because, Sagawa said, it is much more leveraged against corporate IT spending and has far less exposure to the healthiest carriers.
More surprising, perhaps, than the prediction that Lucent would fare better than Cisco was Sagawa’s projections that WorldCom Inc. (Nasdaq: WCOM) and Qwest Communications International Inc. (NYSE: Q) will be among the incumbent carriers to improve this quarter. Another Bernstein analyst, Jeffrey Halpern backed him up on the call, saying that many of the fears surrounding the two companies are not very well founded. “I have a strong belief that they will get through these issues,” Halpern said.
Halpern also rejected the idea that capex will remain low until the carriers have paid off their debts. “Just for them to deliver on the growth expectations that everyone has for them,” he said, “they have to spend some very real money.”
— Eugénie Larson, Reporter, Light Reading