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(BTW, for what it's worth, TMF RFK is now TMF Chris :-)).

Today, Bloomberg reported that Genuity would reduce capital expenditures for the next three years:

3Com also blamed its earnings warning yesterday on telecom carrier spending as well.

(3Com may be wrong to blame the carriers, when it may be their own product mix that is the problem:

This whole issue of carrier cap ex spending has been discussed and debated among analysts and observers for about two months now, as most on this board know. The alleged slowdown in equipment spending by telecom carriers has been blamed for slamming a bunch of next-generation networkers (NGNs -- NT, JNPR, SCMR, CIEN, etc.) in recent months. The concern is not that spending won't increase, but that it won't do so fast enough to justify the high valuations that many NGNs have (or once had).

I've been meaning to try to summarize this debate, as much for my own understanding as anything, though I hope others will benefit from it as well. There have been new wrinkles recently and the whole question of carrier capital spending seems to go back and forth. There certainly seems to be at least a temporary slowdown, but I'm not sure how bad it is or how long it will last. I think it may turn out to be a relatively short-term problem.

Anyway, to recap the debate so far:

In late September, Paul Sagawa of Sanford Bernstein issued a report on networking and telecom equipment companies which basically argued that carrier cap ex spending was growing faster than carrier revenues, a trend he argued was unsustainable, and therefore the spending would inevitably slow. Sagawa also downgraded Cisco, Nortel, and Ericsson as a result.

Initially, most other analysts seemed to disagree, in some cases strongly. Paul Johnson, co-author of The Gorilla Game, and an analyst for Robertson Stephens, issued a report on October 3rd presenting a case for the other side. Since then, we've had a report from Christoper Stix at Morgan Stanley that I wrote about a coupla weeks ago
(, which also gave some credence to concerns about cap spending slowdowns.

In addition, we've had companies such as Nortel Networks find that they weren't able to increase revenues as quickly as the market apparently expected, leading to a slamming of the company's shares, along with several optical equipment companies, such as Sycamore Networks, Ciena, and Corvis. Meanwhile, some telecom carriers such as WorldCom, Williams, and AT&T have indicated they would cut cap spending next year. And now Genuity, for what it's worth.

However, more recently some studies have been conducted that seem to verify, at least in the longer run, the thesis of greater bandwidth demand and greater capital spending by the telecom carriers. In addition, some companies such as Sprint and Cox Communications have
recently announced that they will increase their cap spending next year. These varying factors made me want to write all this down to help clear up my own confusion over all this.

First, let's review the different reports.

Sagawa's report, issued on September 28, does paint a scary picture. The Sanford Bernstein analyst and his crew surveyed 59 North American and European telecom carriers and concluded that telecom equipment spending growth would decelerate from 28% in 2000 to about 19% growth in 2001. While Sagawa acknowledges that carriers usually underestimate their cap spending, he considers a 9% estimated decline large enough to indicate a slowdown of some sort. (The report also draws a distinction between capital expenditures, which include spending for things like laying fiber, and equipment spending, which is a subset and is really what we're talking about here.)

Sagawa's case is based on a couple of things. The first is that the 59 companies he surveyed are "growing their revenues about 13% in 2000, while capital spending [not just equipment] is projected to rise 38%. This means the average carrier is now spending more than 30% of revenues on capital expenditures. At the current pace, capex spending would exceed carrier industry revenues in six years." In addition, Sagawa notes that some of the revenue growth comes from wholesale carriers selling to other carriers, meaning less new revenue is actually coming in to the industry as a whole.

In addition, Sagawa notes that of 41 U.S. carriers, only 4 were free cash flow positive in the first half of 2000. The ability of the other 37 to spend more is therefore limited, at least without external financing, which is harder to come by these days, given CLEC bankruptcies and falling stock prices all around. (The four cash flow positive companies were all ILECs, unsurprisingly: BellSouth, SBC Communications, Verizon Communications, and Alltel Corp., though 360 Networks was close, for whatever that's worth).

Finally, Sagawa concludes that "Current 2001 consensus EPS expectations for a universe of 143 communications equipment companies assume an average 28% increase vs. 2000. If our projection of 19% industry revenue growth is close to accurate [i.e., 19% growth in equipment spending], it is likely that a majority of these companies will disappoint in 2001." Sagawa also singles out the "elite optical and data suppliers" due to their high valuations, arguing that "We do not believe these stocks will be able to sustain their valuation if sales growth is decelerating."

Paul Johnson's report of October 3 represented somewhat of a rebuttal, and has some interesting stuff. Probably the main point of his report is that carriers are faced with a version of the "prisoner's dilemma," which occurs when criminals are arrested and placed in separate rooms. They know that if they all keep their mouths shut they'll be fine, or at least get equal and probably lower sentences, but if any of them squeals, the squealers will reduce their penalties even further, while those who don't squeal will get a worse deal than if all the criminals had kept their mouths shut. So usually they all squeal as a result, to protect themselves.

According to Johnson, telecom carriers are in a similar boat. They might all prefer to forego these high cap expenditures, but can't afford to do so without risking the possibility that one carrier would plunge ahead and build a more advanced, efficient network. In short, as Johnson writes, the carriers have to "pay to play."

Johnson also reiterates what he considers three "first principles" regarding next-generation networks: that customers want new services (speaking primarily of businesses here), and (#2) that these services (high-speed Internet access, broadband VPNs, wireless data) require new networks, and that (#3) the carriers' old services, namely voice, are becoming a low-priced commodity (as we all know). Again, the idea with #3 is that the carriers have no choice.

Unfortunately, this post is long enough. I will finish this up in the next day or two, primarily by looking at some studies that have been done recently that indicate bandwidth demand is not going anywhere. I do have a conclusion in mind!

Comments welcome...hope this is helpful...

Fool on,

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