Network Spending Takes Another Body Blow

Yes, it can get worse.

The nation's biggest phone companies have trimmed about 5% from their 2001 communications equipment budgets, according to first-quarter financial reports, as the economy slows and the telecom industry shakes out. Even so, big phone companies spent more than expected in the first quarter. Strong first-quarter spending and shrinking budgets point to slowing spending on telecom gear sales over the rest of the year, analysts and investors say.

Gear makers like Cisco (CSCO Quote), Lucent (LU Quote) and Nortel (NT Quote) say they were blindsided by the spending pullback. Now, there's more evidence that once free-spending telcos are continuing to downshift their spending in an effort to better align outlays with sales. Judging by the first-quarter numbers, industrywide spending declines could be as deep as 10% this year and 20% next year, say analysts. Those drops will further pressure demand at struggling communications gear makers.

"You hear lots of people saying 2001 is terrible, but I think 2001 has been a year of moderation after five years of gorging on capital," says Lehman Brothers service provider analyst Blake Bath. "The diet will go into its most intense period next year because the industry is still significantly cash-flow negative and many of the emerging carriers are running out of money."

Gorging

For the past six years, phone and Internet service providers have been buying furiously, averaging spending increases of more than 20% annually, culminating in last year's $107 billion capital spending total. But with revenue growth dramatically lagging behind spending growth, many telcos were seeing far more money going out than coming in. That pushed them into the market to seek financing, giving rise to skyrocketing debt levels. And money earmarked for interest payments can't go toward buying new gear.

Reversal Telecom service capital spending, in billions of dollars, jumps in recent years

Source: Lehman Brothers

Networking investors, who in recent years were handsomely rewarded by the phenomenal stock performance of optical component makers JDS Uniphase (JDSU Quote) and Corning (GLW Quote) as well as upstarts like router maker Juniper (JNPR Quote) and optical switch and transport developer Ciena (CIEN Quote), have routinely ignored the fundamental status of the cash-supplying telcos.

You know the story: Cisco -- or fill in your favorite networking name -- makes the gear that runs the Internet, and the future of all commerce was the Internet. That story ignored a leading character in the drama: The companies that had to buy the stuff to build the Internet.

But when the buyer tightens the belt, it nearly strangles the seller. And while the buyers are making their improvements, they are a long way from resuming their free-spending ways, says Bath, who believes a recovery is two to four years out.

"The market is conditioned to aggressive spending increases by the carriers, and they don't believe this is a sustained phenomenon where spending really does slow over a multiyear period," says Bath, who last fall was one of the first sell-side analysts to spot the spending slowdown.

Surprising Strength Tracking capital spending's first-quarter rise from a year ago
Company	First-quarter outlay ($billions)		Percentage change
	2001	2000
Verizon (VZ:NYSE)	$3.3	$2.5	34%
Qwest (Q:NYSE)	2.9	2.2	32
Sprint (FON:NYSE)	1.8	1.4	28
SBC (SBC:NYSE)	2.8	2.3	22
AT&T (T:NYSE)	3.3	2.8	18
BellSouth (BLS:NYSE)	1.6	1.5	6
WorldCom (WCOM:Nasdaq)	2.2	2.2	--
Level 3 (LVLT:Nasdaq)	1.2	1.3	-7
Williams (WCG:NYSE)	0.5	0.6	-16
Totals	19.7	16.8	17
Totals may not add due to rounding. Source: Companies

This kind of outlook doesn't sit well with networking investors who may be thinking that since their stocks are as much as 90% off their highs, that the worst may be behind them.

"Many people are suggesting the worst is over on the spending pullbacks, but we think that is absolutely wrong," says Bath.

Rising

An odd thing happened in the first quarter among the large telcos, the companies that control about 90% of the industry's capital, and it doesn't bode well for the rest of the year. The big phone companies spent more on equipment in the first quarter than they did for the same period last year. On its face, that's good news, since the expectations suggested a sharp spending cut. But since the top nine spenders collectively cut their 2001 budgets by 5% last quarter, spending will likely be sequentially less from here forward.

As first-quarter earnings reports demonstrated, a few factors have emerged to reinforce this downward trend. For one, pricing is coming down. Several of the big telcos, including Verizon (VZ Quote) and Williams Communications (WCG Quote), said that suppliers have lowered prices and that should provide them with about 3% overall cost savings.

Gravity Works Capital spending forecasts dropping
Company	2001 spending forecast ($billions)		Percentage change
	Recent	Original
AT&T (T:NYSE)	$14	$14	--
Sprint (FON:NYSE)	6.2*	6.2	--
BellSouth (BLS:NYSE)	5.7	5.7	--
Level 3 (LVLT:Nasdaq)	3.3	3.4	-3%
SBC (SBC:NYSE)	12	12.5	-4
Qwest (Q:NYSE)	9.2	9.6	-4
Verizon (VZ:NYSE)	17.5	18-18.5	-6
WorldCom (WCOM:Nasdaq)	7.8**	8.5	-10
Williams (WCG:NYSE)	1.6	2.9	-45
Totals	77.3	81	-5
*Note: Sprint has said it is reviewing its budget. Analysts assume the company will cut its budget by 10% to around $5.6 billion. **Midpoint of estimated range. Totals may not add due to rounding. Source: Companies

And as telcos like WorldCom (WCOM Quote) and BCE (BCE Quote) illustrated, buying capacity from other network owners is becoming an increasingly attractive alternative to building network routes. As this trend continues, more money will be diverted from equipment sales.

As upstart telcos such as XO (XOXO Quote) either scale back expansions to conserve cash, or like Winstar and PSINet go belly-up, there will be not only fewer buyers, but less incentive for the established telcos to spend more to keep a competitive edge.

"You began to see some baby steps with pullbacks from larger carriers, but as you see less spending by the emerging players, then you will see greater and greater steps on capital reductions overall," says Lehman's Bath.

Can't Beat 'Em

Even long-time networking equipment bull Greg Geilling of J.P. Morgan has joined the growing bear crowd.

"We have a lot more information [on capital spending] than we did five to six months ago," Geilling said Thursday at a J.P. Morgan H&Q conference in San Francisco. "It's too early to say it's a bottom." Geilling projects spending will drop as much as 10% this year and 15% next year.

Frontloading? First-quarter spending as proportion of recent forecasts
Company	Capital spending ($billions)		First quarter as percent of forecast
	First quarter (actual)	Full year (recent forecast)
Level 3 (LVLT:Nasdaq)	$1.2	$3.3	36%
Qwest (Q:NYSE)	2.9	9.2	32
Williams (WCG:NYSE)	0.5	1.6	31
BellSouth (BLS:NYSE)	1.6	5.7	29
Sprint (FON:NYSE)	1.8	6.2	29
WorldCom (WCOM:Nasdaq)	2.2	7.8*	28
AT&T (T:NYSE)	3.3	14	24
SBC (SBC:NYSE)	2.8	12	23
Verizon (VZ:NYSE)	3.3	17.5	19
Totals	19.7	77.3	25
*Midpoint of estimated range. Totals may not add due to rounding. Source: Companies

These predictions are nearly in line with a report last week from Sanford Bernstein analyst Paul Sagawa, who has been prescient on the spending slowdown. And Susan Kalla, an analyst with Trade.com, has been predicting that network overcapacity, combined with a glut of network suppliers, would cut the cost of bandwidth to all-time lows, below half a penny per minute.

With so many service providers offering cut-rate prices, the cash coming in to these outfits was, in many cases, far less than the cash that was going out to build the networks. This condition, as Lehman's Bath pointed out last fall, was unsustainable.

Bath says the telecommunications service industry as a whole recently has generated about $3 in sales for every dollar it spends, which isn't enough to cover costs, putting companies in a cash-flow negative situation. Telcos, he says, don't get to free cash-flow positive until they bring in about $5 for every $1 spent.

"If you go back to 1985 through 1995, this used to be a pretty stable, predictable industry," the analyst says. "You'd generate $5 in revenue for every $1 that got spent. You were free cash-flow positive every year except for one.

"Now, if forecasts hold true, we will hit about $4.50 of revenue for every buck of capital by late 2003 and into 2004," says Bath. "You need to be in the $4.50 to $5 range just to make the industry a free cash-flow industry."

And then, presumably, networking investors can resume lighting their cigars with $100 bills again.