2002 Preview: Ciscos and Lucents Stuck in Low Gear

The network equipment stocks are going to need more than a Gibson to revive their spirits in 2002.

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You probably know the Gibson as a retro cocktail. Not unlike a martini, it pairs a splash of dry vermouth with vodka or gin, topped off with a pearl onion. It's ever so refreshing after a long, dusty day on the vendor-financing trail, sources say.

For the beleaguered Ciscos (CSCO - Cramer's Take - Stockpickr), Lucents (LU - Cramer's Take - Stockpickr) and Cienas (CIEN - Cramer's Take - Stockpickr), however, Gibson is even more vital. You see, Gibson is Juniper's(JNPR - Cramer's Take - Stockpickr) code name for a new "super router," a piece of gear that directs traffic on a telecommunications network. Gibson can move so much more traffic than existing routers that its rumored introduction in mid-2002 promises to kick off the long-awaited next "upgrade cycle," bulls claim. That is, it promises to tap the first domino that will get the big telcos -- the Verizons (VZ - Cramer's Take - Stockpickr) and AT&Ts (T - Cramer's Take - Stockpickr) -- spending again.

Alas, whether Juniper starts selling this revolutionary new product in 2002, the network-equipment companies are probably in for another long year. All these companies have lost at least half their market value over the past 12 months, and the trends for the coming season look much the same. Before these companies rebound, they will have to overcome a surplus of network capacity and networking gear, reverse a damaging price war and jump-start a stalled product cycle. All this amid a recession and a tech-spending plunge. Good luck, investors.

Half and Half Telecom gear stocks drop 50% and more in 2001

Source: Companies. *projected

Euphoria

As 2001 came to a close, there were vaguely encouraging signs that the economy was starting to find its feet once again. Consumer confidence stopped falling and durable goods orders failed to fall as steeply as expected. Tech stocks rallied sharply off their lows in the year's closing months.

"You can see how there would be reason for some short-term euphoria," says Ariane Mahler, telecom-equipment analyst for Dresdner Kleinwort Wasserstein. But "people have to fight the tendency to think the bad news is all behind us."

Though a cash crunch and stock market contraction wiped away dozens of underfunded service companies, including Winstar, PSINet and 360Networks, the industry is still awash in capacity. Meanwhile, the big, better-funded operators, such as Verizon and AT&T and Qwest (Q - Cramer's Take - Stockpickr), have been slashing their spending plans by the billions of dollars. Each time these big telcos tighten their belts, the equipment suppliers get squeezed tighter.

Of course, at the end of the day, even the spending slowdown at the big telcos can look like a positive if you have the proper rose-tinted glasses on. Sure, if you see spending slide enough, then eventually demand will begin to catch up with supply. But that's putting a next-five-years face on a here-and-now problem.

Falling Telecom spending on the decline

Source: BigCharts, Ciena

"It took years to build the capacity," says Mahler. "It's not going to go away in a short period of time. And it's silly to assume it will all go away because it's Jan. 1."

Mahler is bearish on some of the sector's most popular stocks, including Cisco, Ciena and Juniper. She rates them reduce, her second-lowest ranking. She has a buy on Lucent and former Lucent business-communications unit Avaya (AV - Cramer's Take - Stockpickr). Dresdner has no underwriting ties to these outfits.

Downcycle

If it weren't bad enough to have the economy slowing and tech spending hit the skids, the networking market is now flooded with new and used gear, the driftwood of canceled orders and liquidated operators. Naturally, this makes for cutthroat pricing. And now Cisco has added a new weapon to the price war: zero-percent financing. Considering the company's incomparable financial strength, namely the $20 billion in cash and investments at its disposal, rivals face an even harder time closing deals.

Cisco said it is offering the zero-percent financing to small and midsize businesses with good credit. That segment represents a small portion of its business, the company points out.

Cisco is, of course, no stranger to sales incentives.

In 2001 the data-networking king took a headlong dive into vendor financing, the practice of lending customers money to buy gear. Imagine a convenience store lending indigent customers $10 for a $5 pack of smokes. Of course, unlike Lucent and Nortel (NT - Cramer's Take - Stockpickr), Cisco emerged mostly unscathed from that foray because its lending business was so much smaller than those of its rivals.

Still, critics say zero-percent financing, much like vendor financing, can help artificially stimulate near-term sales at the expense of long-term sales and the bottom line. It could also saddle Cisco with a higher percentage of risky customers. So while Cisco may inevitably swipe market share from rivals, it risks attracting deadbeat customers and depressing its margins. And at the end of the day, investors want profit growth, not just sales.

What They Need

To that end, what the industry needs is a big, hot new-product cycle to kick-start the sales engine again. But as you may have guessed, there's little evidence of any immediate gear-specific buying sprees in the offing.

One exception to that is wireless network equipment. Wireless service providers in Europe and the U.S., if they stick to plan, are in the midst of a tech upgrade to add data traffic to their networks. The assumption is that the investment will yield solid returns when the wireless telcos start selling Internet services to their customers.

Beyond that, there is likely to be steady growth in cable modem infrastructure business as broadband continues to sell. And some speak of a possible router-upgrade cycle to take off late in 2002 with the introduction of, yes, Gibson. But the industry still lacks a new compelling technology to stoke investors' imaginations.

If 2001 taught us anything, it's that supply doesn't trigger demand -- especially when buyers have no money.