By all accounts, network equipment makers should be lighting their cigars with $100 bills this summer.
Telcos keep ordering gear to handle the inexorable rise in U.S. phone and data traffic, and these network operators are spending big to get new optical-based systems in place now.
But by stinking up the works in January with a miserable quarter,
introduced a note of uncertainty that still lingers: Can suppliers raise output enough to avoid getting swamped by demand?
Answers should start coming Thursday morning, when Lucent is due to report fiscal third-quarter earnings. Meanwhile, rival
is scheduled to post earnings July 25, and
is set to report early next month. Investors will be keeping an eye on whether revenue growth keeps pace and whether margins remain solid. Shortfalls in those areas could indicate that demand is overtaking these companies' ability to keep customers happy.
Happiness Is a Warm Gun
Network operators big and small, new and old, continue to line up for new gear that will help them build ahead of the steeply projected surge in Net traffic. U.S. phone and data communications companies are expected to spend $104 billion this year on equipment, according to
Credit Suisse First Boston
analysts, up 32% from 1999.
The Low Road
Much of this cash flows in a direct line to the established suppliers such as Nortel and Lucent, the industry's two largest incumbent equipment makers. But as Lucent investors have learned, buying trends are shifting quickly from old phone machinery to new Internet equipment, and data gear makers like Cisco and
are tapping a greater share of the deal flow in some select categories. Meanwhile, emerging optical-networking firms, including
, continue to increase the traffic capacities in their optical boxes, aggressively attempting to capture the market's leading edge.
That action has driven shares in these companies, save Lucent, sharply higher over the last year as investors sought to play the telecommunications boom.
For Lucent, six months after investors fled in a huge selloff triggered by the company's outright
failure to meet this exceptional demand, rising overhead costs and narrowing gross margins remain a concern.
New financial chief Deborah Hopkins, a recent defector from
, faces the tall task of restoring Lucent's credibility on the Street. Last quarter, for example, Lucent was thought to be
squeezing certain expenses to present a gussied-up picture.
This time around, the true test of Lucent's health will be in its revenue growth, says analyst David Toung of
, which doesn't do investment banking. "You can't fudge top-line growth," says Toung, who has a hold rating on Lucent and buys on Cisco and Nortel.
Lucent shares have dropped 22% from their 52-week high at the beginning of the year, though they've rallied in the last week amid enthusiasm that the company will report a solid quarter. (
this phenomenon in a piece Monday.) The company is expected to report that fiscal third-quarter earnings jumped 31% to 29 cents a share.
Like Lucent, Nortel's critical question this quarter is whether it can continue to meet the enormous demand for its equipment. This is no easy task during a time of constrained component supply and manufacturing space.
Five years ago, Nortel shifted its focus to high-performance optical equipment and has since staked itself to a sizable lead in new-generation wave-division multiplexing, or WDM, gear. These devices act like prisms to separate light into various color paths to maximize fiber-optic cable capacity.
telecom analyst Mark Lucey says he expects Nortel to book $10.5 billion in revenue this year from optical-network equipment sales -- a half billion above company guidance. Lucey is looking for more detail in Nortel's optical picture, but says he expects the company to damp expectations following last quarter's upside surprise. Analysts expect the company to earn 15 cents a share for the quarter.
Another concern is margins. Oddly, Nortel has been cutting prices in the WDM market it already dominates. It's not clear whether sacrificing price for greater market share is necessary or will continue, but Lucey says there is some logic to it.
"There is an incentive, if you take a longer-term view, to getting the market share upfront to gain a stronger franchise down the road," says Lucey, who has a buy on Nortel. (TD Securities has done underwriting for Nortel.) In other words, if telcos build their new networks on a Nortel foundation, they will likely return to Nortel for add-on equipment and software. At that point, says Lucey, Nortel's margins will likely expand.
The Third Way
With Lucent the acknowledged laggard and Nortel the runaway leader in optical networking, Cisco is left somewhere on the outside, trying to find a way into the market. For all its swagger, having trounced the business-data network market for a decade, Cisco has found it has to start playing it more carefully in the larger network market.
"Cisco doesn't want to set expectations too high right now," says Argus' Toung. "There is a huge scale of difference between an office network and carrier network. And Nortel and Lucent still have the advantage."
On the optical front, Cisco has had some success with its
products: Sales of the metro, or edge network, gear are expected to hit $1 billion this year. But Cisco is actually
losing market share with its
products and has yet to release a
optical switch a year after it acquired the company.
Investors will be watching to see how well Cisco's margins hold up as the company mixes more products into the revenue stream. While Nortel is selling cheaply to stay atop the market, Cisco may have to sell cheaply just to get in. Nonetheless, the strength of Cisco's router business should help mask these potential weaknesses for now. Analysts expect Cisco to earn 15 cents a share for the quarter.
As originally published, this story contained an error. Please see
Corrections and Clarifications.