For Telecom-Equipment Stocks, a Rare Trip South

The chill in the networking sector is spreading.

Recent days have seen a selloff among the telecom-equipment stocks that have led the Nasdaq's rally over the last year. Why? After two years of leadfooted capital-spending growth, phone companies and Internet service providers are easing off the telecom-equipment gas pedal, and Wall Street is taking notice. Tuesday has seen some of these stocks recovering, but even red-hot outfits like Corning (GLW Quote) are now 10% or more off their highs. Optical juggernaut Nortel was off $2.31 Tuesday afternoon at $66.75, putting it nearly $10 below its Thursday close.

Gravity Returns Networking shares recede

Depressed stock prices, declining revenue growth and limited access to cash are among the factors crimping the once free-spending service providers, which buy the gear that networkers make. While the massive spending on this gear fed a huge boom in networking stocks over the last two years, any pullback stands to be potentially devastating for these richly priced shares. TheStreet.com explored these trends in several stories over the last month.

The Squeeze

With spending growth poised to recede, investors are starting to worry about valuations in the networking and telecom-equipment sectors. As a result, the last two weeks have seen sharp selloffs in the shares of these companies, from giants Nortel (NT Quote) and Cisco (CSCO Quote) to optical equipment start-up Corvis (CORV Quote) and Internet gear pusher Juniper(JNPR Quote). Indeed, the past two days have wiped billions off these company's valuations, as Wall Street begins to consider whether the golden age of telecom spending has passed on.

Another sign of a change: For the past several days, analysts who have traditionally been bulls on the telecom-services sector have been pointing to these pressures. They expect something -- capital spending, most likely -- to give at beleaguered big spenders such as AT&T (T Quote), WorldCom (WCOM Quote), Sprint (FON Quote), Qwest (Q Quote), Williams (WCG Quote), Level 3 (LVLT Quote) and others. J.P. Morgan analyst Tod Jacobs, for instance, predicts a shakeout through consolidation and cuts in spending.

As Lehman Brothers analyst Blake Bath pointed out in a report last week, network builders' recent bout of record spending has coincided with a period of dramatically falling long-distance revenue. Bath predicts that the industrywide ratio of revenue to spending will hit an unsustainable 2:1 next year. Inevitably, service providers will need to squeeze money out of equipment investments, he says.

The Peak

Bath says the large-cap telcos will hit their peak spending next year and "then it will ease off dramatically from there." Another dyed-in-the-wool bull, Credit Suisse First Boston's Dan Reingold, echoes that point.

Tough Year Big telco shares slide

Source: BigCharts

"My numbers for 2001 show a deceleration in the rate of capital expenditure growth," the analyst says. "There was over 30% growth this year in cap ex, and about 20% in 1999, and next year we see a deceleration to 10% growth."

Of course, Reingold sees this as good news for service providers that can stop bleeding money and start selling services. And, for the equipment makers, he says it's not exactly the end of the world.

"This is a peaking process, if they spend $100 billion this year and $110 billion next year, those are big numbers and that's a lot of equipment," says Reingold.

Indeed, and spending is likely to continue to be lush even if growth slows. As telecom service companies have raced to build a bigger Internet, the networking industry has enjoyed two years of phenomenal outlays. This year, equipment spending is expected to reach $115 billion in North America, according to Credit Suisse First Boston.

The Strain

But signs of strain are starting to show already. Williams Communications, which is in the process of building the nation's third-largest fiber-optic network, has recently found cash a little harder to get a hold of. Williams had to liquidate its shares of optical switch maker Sycamore (SCMR Quote) to raise cash, and says it will also sell Corvis (CORV Quote) and optical gear specialist ONI (ONIS Quote) shares to raise more money when possible.

This has brought added pressure to the optical equipment makers that count on new fiber-optic network builders such as Williams, Broadwing (BRW Quote), and Qwest as customers and also investors.

As competition increases and funding tightens, these upstart network builders and their suppliers are the most vulnerable.

"The emerging companies' spending has been far less productive than one might expect in terms of the revenue they have been able to generate on it," says Lehman's Bath. What makes matters worse for the new entrants and would-be start-ups is that a roster of tracking stocks and spinoffs are scheduled to hit the market. Those new issues will hog available investment money, toughening the going for less-established players, says Bath.

"A big part of me hopes I'm wrong on this," says Bath. But the evidence points to further pullbacks in these stocks.