Sector Spotlight: Networkers Talk Rebound, but Evidence Is Scant

With the networking sector halfway through earnings season, a clear pattern has formed: A cash shortage among the buyers is coming home to roost among the sellers.

Yet just as networking gear makers such as Cisco (CSCO Quote), Nortel (NT Quote), Juniper (JNPR Quote) and ADC Telecommunications (ADCT Quote) are finally conceding they're feeling the effects of a slowdown in equipment spending, almost in unison they're calling for a rebound later this year.

But some industry observers have grown largely skeptical of forecasts from the very companies that just a few months ago didn't see a slowdown coming. In fact, even in the best of circumstances these companies face a difficult challenge in managing the great expectations of a continued Internet build-out while financing vanishes and builders fail.

The bottom line: Even in an easing rate environment, telecom equipment spending isn't likely to immediately rebound to last year's sky-high levels. That means more tough going for these stocks, investors say.

Stopping on a Dime

After languishing in the denial stage for months as one customer after another reined in capital spending, the equipment makers now appear to have bypassed the anger stage and begun the bargaining. For example, in its earnings discussion with analysts Thursday, Nortel repeated what Cisco CEO John Chambers said the week prior: If the Federal Reserve were to continue lowering interest rates, the sagging economy would begin to stabilize in a matter of two quarters or so.

"Some of these companies may be giving investors false hope. There's no reason to think that lower interest rates will mean the bad times are over," says a New York networking analyst who asked not to be identified. Even assuming further rate cuts, "We are simply not going to see a one- or two-quarter turnaround in the spending slowdown," the analyst says.

Whatever the Fed does, plenty of other weak spots remain to be resolved.

Chief among telecom firms' troubles is the unexpected and dramatic evaporation of profits from long-distance service. That big cash spigot was expected to fuel the equipment purchases for new-generation networks. Instead, companies like AT&T (T Quote) and WorldCom (WCOM Quote) fell to pieces in recent months as shriveling revenue forced them into restructuring plans. And without the big cash flows, many of the telcos, large and small, had to turn to the debt market for cash.

But with the economy slowing and the markets awash in telecom debt, the industry confronts a global debt crisis that is punishing all the big buyers, including Deutsche Telekom (DT Quote), AT&T, WorldCom and British Telecom (BTY Quote), says North River Ventures' Francis McInerney, a venture capital consultant to the telecommunications industry.

"The debt crisis has come on very fast and is hitting very hard," says McInerney, who co-authored the book Futurewealth, an examination of the business models of companies, including Cisco. "It has forced most carriers to chose debt service over buying new products, and that will take the wind out of your market pretty quickly."

Job One

Even a reduction in interest rates, while somewhat soothing, won't begin to solve the problems that got telcos into debt in the first place, namely the deterioration of their business. As the economy weakens and businesses start keeping a closer eye on their spending, merely staying afloat becomes job one. That pushes capital spending to the back burner.

"If all of a sudden S&P downgrades your debt and it becomes far more expensive than it was," says McInerney. "The first thing that goes is all the new stuff you were buying from Cisco, Nortel and all the others."

So do the Fed's efforts to revive the economy validate the prediction that growth will rebound enough in the second half of the year to make up for the slowdown?

"Absolutely not," says one hedge fund manager. "But it gives them someone to blame if they fail to meet expectations for the year."