SBC Leading Baby Bells to Spending Sanity - TheStreet

Updated from 10:48 a.m. EST

Thursday brought more bad news for the telecom sector, unless you choose to take the longer view.

SBC

(SBC)

, the big local phone company in the southwestern U.S., on Thursday reported weak fourth-quarter earnings while forecasting a continuing slowdown in its core business. Saying it's focusing on the bottom line, the company rolled out a plan to cut back on capital spending while hinting that further job cuts could await. SBC shares, which have fallen some 20% over the last year and are just above a 52-week low, added 7 cents to close at $36.15.

Reduced spending even at the cash-generating Baby Bells clearly means bad things for the rest of the sector, from the equipment makers like

Lucent

(LU)

to the component outfits like

JDS Uniphase

(JDSU)

, set to report earnings later Thursday. And given the spending discipline that SBC has adopted, observers expect rival

Verizon

(VZ) - Get Report

, the nation's biggest local phone company, to follow suit with its own capital spending cuts next week.

But the bull story is that the big phone companies are at last returning to their prebubble spending discipline. While that probably means deeper-than-expected cuts now for equipment suppliers like

Cisco

(CSCO) - Get Report

,

Ciena

(CIEN) - Get Report

, Lucent and

Nortel

(NT)

, it also means the industry's big spenders are bringing their outlays back into line with historical norms. That is to say, spending isn't going to keep plunging the way it has the past two years.

"The spending levels we are seeing now at Verizon are about as low as they can go," says Sam Greenholtz, an optical analyst at telecom research and consulting firm Communications Industry Research. Executives tell him Verizon will cut its capital spending to $13 billion for 2002, from some $17 billion in 2001. "They're only spending where they have to, and that takes away all discretionary purchases."

As recent history has shown us, it's the telecom-spending tail that wags the networking-industry dog, from the makers of the biggest switching gear down to the suppliers of the tiniest chips.

In the late-1990s Internet-building era, cash rushed out of phone company spigots and into the coffers of dozens of networking-equipment suppliers. Then, when investors bolted from the phone companies in late 2000 and all last year, the money flow to gearmakers evaporated. As a result, the telecom-networking group has seen its shares drop by 75% and more over a year, amid a torrent of red ink and thousands upon thousands of layoffs.

Analysts like Lehman Brothers' Blake Bath flagged the

unsustainable trend staked out by service providers during the building boom: He notes they were spending as much as $1 for every $2 they brought in, which is more than double their long-term average.

Now, the latest round of spending cuts is bringing the return of the old notion that telco capital spending should be perhaps 15% to 20% of revenues.

Take SBC, for example. The nation's No. 2 local phone company, which is expected to have $55 billion in revenue this year, said Thursday that its 2002 equipment budget is now $9.2 billion, or 17% of sales.

CIBC World Markets analyst Tim Horan sees SBC's new lower spending level as just a shade higher than what's known as maintenance-level spending, the routine replacement of old gear such as copper lines and hardware system cards.

SBC has "no line growth and no volume growth, so what are they going to spend any money on at this point?" asks Horan, who has a strong buy on SBC. His firm has no underwriting ties to SBC.

Similarly, Greenholtz predicts Verizon will cut spending by 26% from last year's levels. The new $13 billion target is about 18% of Verizon's projected 2002 revenue. Verizon declined to comment, but a representative said the company will discuss its spending plans during its Jan. 31 earnings call.

While it's easy to interpret rock-bottom spending as more bad news, industry observers point out that such a shift will help correct the excesses of the past two years. So now, as revenues start to stabilize for the telcos, spending will at least be more predictable, if not poised for immediate increases.

For investors perpetually lashed by news of spending cuts for the past 18 months, any hint of a letup is bound to be a welcome change.