Trickle-Down Teleconomics By Cody Willard Special to TheStreet.com 4/24/01 1:48 PM ET

Over the past few weeks, telecom equipment vendors' stocks have made impressive moves. Juniper (JNPR:Nasdaq - news - boards), Ciena (CIEN:Nasdaq - news - boards) and ONI Systems (ONIS:Nasdaq - news - boards) have more than doubled off their recent lows.

I recently pointed out that the companies that build the best boxes will be the ones that see the current telecom recession turn first, or at all. And their stock moves suggest things might be getting better, that demand is beginning to pick up and that perhaps the worst is finally behind us.

The companies that ultimately put these products to work are the service providers. So, for the equipment manufacturers to regain any lost visibility, service providers have to begin to order more products. The question then is, what are service providers telling us?

Winstar declared bankruptcy, and while it will probably emerge pretty much intact, the company will never be able to spend the billions it blew through over the past few years. Level 3 (LVLT:Nasdaq - news - boards) guided revenue estimates significantly downward when it reported earnings this week, revealing that it is beginning to feel effects from tighter customer purse strings.

Furthermore, Level 3, Williams (WCG:NYSE - news - boards), Global Crossing (GX:NYSE - news - boards) and the rest of the alternative long-haul crew have nearly completed network expansions, and will be lowering capital expenditures over the next few quarters. They'll continue to expand and innovate and grow their networks, but from here on out will largely have to fund their spending without the assistance of the capital markets.

Here's why:

There has been a shift in market mentality toward service providers. Two or three years ago, the market rewarded these companies for expanding and growing networks at a maddening pace. But now, the market punishes them for spending money. Think about what a difference that is going to make. In years past, service providers actually saw their stock prices go up from buying more equipment from the vendors. Now, the opposite mentality pervades the market.

In some ways, the market is finally back to making sense. It is now requiring service providers to slowly build out business plans, forcing companies to prove their concepts. The only service providers whose stocks are showing resiliency are those with a possibility of becoming profitable before interest, taxes, depreciation and amortization. And these companies sure don't meet that mark by spending billions on equipment.

What all this information tells us is that the equipment vendors need to focus their efforts on incumbent local exchange carriers like Verizon (VZ:NYSE - news - boards), SBC (SBC:NYSE - news - boards), BellSouth (BLS:NYSE - news - boards) and Qwest (Q:NYSE - news - boards).

The traditional long-distance carriers like AT&T (T:NYSE - news - boards), Worldcom (WCOM:Nasdaq - news - boards) and Sprint (FON:NYSE - news - boards) also are big targets for the equipment vendors, despite the companies' commitment to spending less on capital expenditures in recent months.

As I've said before, there is still a bunch of money to go around, and I expect many of the equipment vendors to begin to see a turn in their business prospects over the next few quarters.

The equipment vendors aren't the only ones whose stocks have made big jumps recently. Telecom component suppliers' stocks, too, have made giant moves. PMC-Sierra (PMCS:Nasdaq - news - boards) and Applied Micro Circuits (AMCC:Nasdaq - news - boards) are both up about 1.5 times above their recent lows, and JDS Uniphase (JDSU:Nasdaq - news - boards) has doubled.

The companies that use these component suppliers' products in equipment are, of course, the equipment vendors. And for the component suppliers to regain any lost visibility, the equipment vendors have to begin to order more products. The question then is, what are the equipment vendors telling us?

Cisco (CSCO:Nasdaq - news - boards), with its "100-year flood" comments, is writing off $2.5 billion of inventory, much of which is component inventory. Juniper, Nortel (NT:NYSE - news - boards) -- and nearly all other equipment vendors -- have guided sales numbers down because they overestimated demand.

Most equipment vendors have a glut of component inventory to work through before they begin to place serious orders again. None of this bodes well for the component suppliers. Remember, they were the last to see the collapse, and they'll be the last to see the recovery.

What I'm saying is that I still believe the best equipment vendors will be the first to see demand increase. So, I expect Juniper, which makes a product that is fundamentally necessary in today's and tomorrow's IP networks, and Extreme (EXTR:Nassdaq - news - boards), whose Ethernet switches are sold to both telecommunication companies and enterprises, to be among the companies to see business turn first.

ONI Systems, whose products have quickly proven to be the best in its sector, continues to see strong demand, and I don't expect that to change.

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