Qwest Cuts Back, and How

Network-building efforts take to the back burner.
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Cutting costs to the bone, Qwest (Q) CEO Joe Nacchio told contractors to stop network construction immediately, setting off alarms among networking gear suppliers.

Just one day after Nacchio

raised the specter of dramatic spending cuts on an earnings conference call, the Denver telco took the unusual step of ending contract work on its network. Shares of Qwest and its biggest suppliers dropped as investors deduced that telecom spending may now drop even more sharply than during the first year of the industrywide recession.

Wednesday, Nacchio presented investors and analysts on a postearnings conference call with a worst-case scenario that essentially envisioned no network spending by Qwest for 2002 except routine maintenance work. In making that claim, Nacchio sought to show he's in control of the business despite the deteriorating economics of the telecom industry.

But Nacchio may have misjudged how Wall Street would interpret that stance. It seems investors saw it not as a sign of strength, but as a dire warning that cash-burning, debt-laden Qwest was suddenly thinking in terms of worst-case scenarios. Qwest shares fell 25% in the days following Nacchio's remarks. They were off 35 cents Friday at $11.65.

"That they are going to stop spending is pretty Draconian," says Friedman Billings Ramsey analyst Susan Kalla. "I think this is a leading indicator of the level of deterioration in long distance and the inevitability of the consolidation of long distance into the Baby Bells."

Qwest says the move, which came to light when an internal memo was leaked to Web site F***edCompany.com, will allow the company to assess the costs of such things as contract labor as it seeks to manage in a "down economy."

"We've informed our vendors and contractors that we want to stop all work and that we'll continue to evaluate as we move forward with our 2002 plan," said a Qwest spokesman.

Management hinted Wednesday that deep cuts would come soon. Lehman Brothers analyst Tim Luke says management confirmed it would take fourth-quarter spending down to $700 million from the $2 billion to $3 billion initially expected for the quarter.

That will certainly deal another blow to the networking industry, which has already suffered over the last year of spending cutbacks and retrenchment. "We'll be looking at the equipment that has been shipped and evaluating whether it needs to go in immediately or long term," Qwest said.

Among the suppliers most vulnerable to Qwest cutbacks are

Ciena

(CIEN) - Get Report

and

Juniper

(JNPR) - Get Report

. Sales to Qwest represent about 25% of Ciena's revenue and 10% of Juniper's, according to Kalla, who rates Ciena and Juniper underperform. Both stocks fell about 8%-10% Friday.

Juniper was unavailable for comment. A Ciena spokesman didn't know how much sales could be hurt by Qwest's cutbacks. "We'll have to see what this means," the Ciena spokesman said.

Qwest has proven to be a frightful customer for Ciena of late. Last month, Qwest asked Ciena and Nortel to cut prices on an existing contract. To many observers, the request put the network gear makers in a tough spot, choosing between skimping on profits and losing business altogether. In the end, Ciena ended up taking all the business, albeit at a sharply reduced price.

Qwest's capital expenditure budget was $8.5 billion this year, making it the fourth-largest equipment buyer in the industry. Qwest has said that 2002 spending will drop to $5.5 billion; it added Wednesday that it could slash spending to as little as $2 billion next year, if it funded only basic network maintenance work. Other big telcos such as

WorldCom

and

SBC

have indicated they'll cut 2002 spending by around 20%.

Qwest posted very disappointing third-quarter results Wednesday, losing 3 cents a share as revenue fell 9% sequentially. Gross margins narrowed by 2 points to 37%.

Investors have not had an easy time following the ever-morphing identity of Qwest. Right out of the gate, Qwest was billed as the "ride the light" national fiber-optic network of the future. Less than a year later, in an effort to find actual traffic to ride on the light, Qwest merged with Baby Bell U S West.

That sudden strategic shift caused Nacchio to alter his message, and soon he was telling Wall Street that Qwest was the ultimate hybrid network, what all networks will look like in the future. Now the cost of completing the national fiber optic network is dragging down the more stable U S West business, and whether Qwest is the future network of anything is increasingly anyone's guess.