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No. of Recommendations: 38
(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: http://news.cnet.com/news/0-1004-200-4003150.html?tag=st.ne.1004.thed.ni

3Com also blamed its earnings warning yesterday on telecom carrier spending as well. http://www.fool.com/news/breakfast/2000/breakfast001205.htm
http://news.cnet.com/news/0-1004-200-3990521.html?tag=st.ne.1004.ttext.ni

(3Com may be wrong to blame the carriers, when it may be their own product mix that is the problem: http://news.cnet.com/news/0-1004-200-4006833.html?tag=st.ne.ron.lthd)

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
(http://www.fool.com/news/2000/jnpr001121.htm), 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,

Chris
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No. of Recommendations: 9
TMFChris:
"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," "

How interesting, I was just reading up on Game Theory and the Prisoner's dilemma recently. It really does explain why all telco's will be building, and spending on CapEx.
The "Prisoner's Dilemma" as applied to the Telco Carrier situation can be illustrated by the following diagram:

Other Telco
Y Don't build build
O Don't build (10,10) (0,20)
U build (20,0) (5,5)

The table is read like this: Each Telco carrier chooses one of the two strategies. In effect, the "Other Telco" (your competition) chooses a column and you choose a row. The two numbers in each cell tell the outcomes for the two Telco carriers when the corresponding pair of strategies is chosen. The number to the left of the comma tells the "payoff" to the person who chooses the rows (you) while the number to the right of the comma tells the payoff to the person who chooses the columns (the "other Telco"). Thus (reading across the first row) if the "other Telco" chooses NOT to spend on new NGN equipment and you choose also choose NOT to spend, then you both get $10 payoff (not actual revenue, but you get a "payoff" in the form of cost savings). However, if the "other Telco" chooses to spend on new NGN equipment, and you choose NOT to, then you get $0 payoff, while the other Telco company gets $20 payoff (from increased mkt. share + incr. revenue that the better NGN equipment brings in).
The case where you and the other Telco both spend on new NGN equipment results a low payoff of $5 for both players (because you take on more risk/reward, and you split the market share, and therefore get less revenues).

The dilemma is as follows:

Let's say that the other telco company doesn't spend on NGN equipment (reading down the 1st column). Then it is in your best interest to spend on new NGN equipment (you get a higher payoff, as shown in the table). On the other hand, if the other Telco chooses to spend on NGN equipment, then it's still in your best interest to spend on NGN equipment (you still get a higher payoff). Therefore, you decide to spend on NGN equipment.

Guess what?

The other Telco will be rationalizing in the exact same way, so then the both of you wind up spending on new NGN equipment, resulting in the lower payoff than if both of you chose NOT to spend. The ideal scenario where no one spends on NGN equipment never becomes reality, if all the telco carrier reason the same way.




Thx.
cheers,
Albert
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No. of Recommendations: 5
Chris, thanks for pulling some of those things together and mulling over the telecom capex issue.

One thing bedeviling the discussion, I think, is that Sagawa essentially said some higher-priced optical stocks were over-valued. This could be true regardless of the specific consensus growth outlook, since valuation multiples can and sometimes do change independently of any growth forecasts. So it wouldn't be hard to grant that perhaps some high-flyers were richly priced, whether one bought the overall Sagawa forecast or not. My own take on Sagawa's analysis was: correct about over-valuation, but probably quite incorrect about growth picture.

Sagawa says he accounted for habitual telco low-balling of future capex spending, but perhaps he didn't compensate enough.

I try to read all the readily available reports on the subject, but stepping back and being logical about it, it's not hard to reduce the picture a bit to the key things I care about as a LTB&H telecom equipment investor. Trying to sort out the ultimate merits of conflicting forecasts --- all of them subject to a robust range of error --- seems pointless, not to mention infeasible.

My investments in the sector are based on the premise that the best companies involved in the new telecom network infrastructure build-out will face sustained and superior medium-long term market opportunity and growth prospects relative to most other sectors. Clearly not the only sector like it, but one of the biggest and most certain to experience a prolonged growth phase.

It's perfectly normal for there to be bumps in the road, whether caused by sector distortions (overly ambitious build-out plans, or schedules, business models that don't match revenue needs in changing financial climates, etc.) or overall capital market problems. If Sagawa's thesis about revenues not supporting capex growth rates proves correct, it will only be correct for a brief period (as viewed from a longer term perspective). The underlying, prolonged trend will not likely change: a massive, global, multi-faceted infrastructure investment and upgrade effort that presents huge opportunities for the best vendors.

But even though I'm comfortable with the sector fundamentals, long-term, there's endless variety to the ways in which particular stocks can swoon or soar, in the short term.

Take NT. One of my largest positions and an old one (long before the optical stock mania). I sympathize with those less fortunate whose cost basis is higher, but the happenings since NT's 3Q announcement have been almost comical. The analysts keep moving the goalposts. A very vague comment by John Roth becomes a "forecast" that must be met by NT. Spectacular, nearly unbelievable growth numbers are deemed to have fallen short in some way --- even though they confirm a market dominance that none of the analysts had predicted. When the company reiterates their unchanged outlook for a third time, somebody, seemingly almost in desperation, invents yet another new benchmark (implausibly huge number, with no official basis at all) that NT had failed to meet.

I don't know what's going on with these people, and I don't much care -- nothing they've come up with has altered my conclusion that in the years ahead the market will reward NT for its continued success (assuming they execute). None of which is to say that NT wasn't ahead of itself --- probably was.

Sagawa's forecast didn't give any reason to modify our view of the longer term trend. So even if, against the evidence, he proves correct, it's not of great concern (unless you're planning to cash out your optical stocks in the next 12 months and live off the proceeds).

Sorry for the ramble. Thanks for your contribution.




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No. of Recommendations: 1
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."

Problem is some of the big boys are running out of cash needed to remain in the game. AT&T has huge debt as a result of its failed strategy of cable acquisition. Moodys, S&P and others have downgraded the debt once and threaten to lower it further if the breakup proceeds. T has a depressed stock price and only $300 million in cash as of the last reporting date. It has cancelled cap ex orders to conserve cash.

Half of T's $62 billion in debt is short term. It must be refinanced within one year. Interest already takes 1/4 of T's annual cash flow. If the debt is downgraded, interest cost will increase from a present $3 billion annually to God only knows what.

Point being, T's role in this capex spending wars will, of necessity, be greatly reduced or eliminated until it solves its debt problems. Add this to the well documented woes of the startup carriers and you have a bleak picture for ongoing capex spending.
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No. of Recommendations: 6
Point being, T's role in this capex spending wars will, of necessity, be greatly reduced or eliminated until it solves its debt problems. Add this to the well documented woes of the startup carriers and you have a bleak picture for ongoing capex spending.

Don't forget the rest of the world. The instrastructure build out for cable, DSL, fiber, wireless and satellite is not llimited to US only. Likewise, budgets for companies in other global areas are just as prone to cuts as US companies. It's a maximum pain, high switching cost proposition. It won't be built out in one year, two years, three years. It will take 5 to 10 years minimum and the life cycle might last as long as 20 years. It's worth continued study for all of us and we have to keep in mind that growth comes in waves and the economic conditions as well as credit issues are all a natural part of the process.

Continue to watch the number of deals inked in Asia and Europe for these global players. Not only in enabling hardware, but software as well.

BB
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As you do your research, keep in mind that voice revenues are shrinking for all the carriers while data revenues are growing. Combine that with the very high cost of traditional voice switching products vs. the low cost, but lower reliability, of VOIP. VOIP also adds the benefit of allowing one network for data and voice. (innovator's dilemma?)

My personal view is that NT, LU and other traditional telecom equipment makers will have an incredibly difficult year in 2001. Purchases of traditional equipment, which still dominate their sales, will shrink. Even as their optical/data product sales grow, the drag from the traditional products will be a problem. NGN companies sales numbers are much smaller and, therefore, easier to keep on a growth path.

I do not have direct evidence for this observation, but the reports from the CSCO analyst meeting seem to support this analysis. Will keep looking for more.....
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No. of Recommendations: 2
I do believe there will be a lot of spending on equipment for the future, but it is extremely unclear to me if it will be anywhere hear the amount required to justify the gigantic market caps in the big network equipment providers: CSCO, LU, NT, JNPR, EXTR, RBAK, SCMR, et al.

Keep in mind that the internet implosion has significant ramifications for all of the network equipment providers as well:

If internet companies cannot make money, then it is quite clear that the profit impact of the internet is nowhere near what it has been hyped up to be, at least for the short term.

Where then is the profit incentive? Low or no profit on internet = low or no profit for internet companies = low or no profit for internet services providers (not merely ISPs, but Akamai, PCLN, DCLK, EXDS and B2B and B2C consulting/hosting) = windfall profits for bandwidth providers? This does not a sustainable business model.

What has happened in the past is that network equipment providers were being bolstered both by the imminent huge profits speculated for internet businesses hence bandwidth demand and simultaneously by the huge existing profit stream of voice business.

Follow the money:

As of 12/7/00
Company MarketCap
LU 48.6B
NT 117.6
CSCO 351.7B
JNPR 47.3B
EXTR 7.8B
RBAK 12.5B
SCMR 15.5B

Total Provider Market Cap: 601B
(Note that I did not include optical companies such as Corning, JDSU, et al; nor did I include the cellular equipment manufacturers such as Nokia, Ericcson, Motorola, et al)

Customer MarketCap
T 73.9B
FONE 20.3B
WCOM 42.8
GENU 4.3B
VOD 223.7B
NTT 132.7B

Total Customer Market Cap: 497.7B

Of course, you can point to other examples which are different - INTC, MSFT, perhaps a few others - but then again Intel has a virtual monopoly and Microsoft has been proven to have a real monopoly.

The last note is that the Prisoner's Dilemma is not fully applicable here. It is quite conceivable that the above customers band together in a bargaining collective; all of the above companies can communicate with each other which the prisoners in separate cells cannot. One cannot assume the old style "Nature, Bloody in Tooth and Claw" competition.

http://www.cooky.demon.co.uk/easter/e1996a.html

The buildup in question also involves a lot more than just equipment; for example a company which owns or controls the easements through and in which equipment/lines must be placed has significant power.
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Don't forget the rest of the world. The instrastructure build out for cable, DSL, fiber, wireless and satellite is not llimited to US only.

Good point. However, this adds additional risk - currency - for U.S. investors.

BTW, what do you think of BKHM at current prices? Would really like your opinion. I'm thinking of jumpping into this one.
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