Dieting wasn't enough for the big phone companies. Now they're embarking on a capital-spending fast that could starve their already famished suppliers.

The telecommunications industry has been queasy for quite some time, in the wake of the Internet building boom that flooded the sector with weak players and unneeded capacity. Ever since 2000 the big telcos have been tightening their belts in an effort to reverse a long slide in revenue and profits.

But just in the last two weeks the big players have been wielding the knife more savagely than ever, slashing already shriveled 2002 spending plans by a stunning $4.5 billion. With those cuts, which accompanied a widespread selloff provoked by a series of depressingly weak first-quarter earnings reports, the telecom giants have cut their 2002 capital budgets by an aggregate $18 billion -- 29% from a year ago.

As we have seen time and time again, what's dismal for telcos translates to sheer misery for their suppliers. Outfits like

Lucent

(LU)

,

Nortel

(NT)

,

Ciena

(CIEN) - Get Report

,

Corning

(GLW) - Get Report

and a roster of other struggling network gearmakers have already cut their operations by half in an attempt to adjust to a starkly lower product demand. All those onetime highfliers now sport stocks in the single digits, with Lucent and Nortel both south of $5, after more than a year of round-the-clock cutbacks.

This most recent round of

spending cuts by

AT&T

(T) - Get Report

,

Verizon

(VZ) - Get Report

and

WorldCom

(WCOM)

, to mention a few, will likely test anew the gearmakers' assumptions about staff levels, production capacity and revenue projections. And ultimately, for investors, it will raise renewed doubts about the recovery of these stocks.

Health Talk

Clearly, the new cuts come as little surprise, given the financial turmoil nearly every phone company has encountered in recent months. Even rock-solid Verizon was put on alert last month for a downgrade by both S&P and Moody's. The credit rating agencies were concerned about the company's $62 billion debt level.

"What's driving capital spending is the carriers' financial health," says Dresdner Kleinwort Wasserstein analyst Ariane Mahler. "On one side, they have the rating agencies pressuring them about their debts, and on the other side they have investors demanding better cash flow. So guess what? They cut capex because it is the easiest thing to do." Mahler has a buy rating on Lucent and rates Nortel a sell; Dresdner has no underwriting ties to these companies.

With spending cuts serving as the obvious short-term remedy to rising tides of red ink and debt payments, not all analysts think the gloom is as dooming as it would appear.

Some observers, including Sanford Bernstien's Paul Sagawa, Banc of America Securities' Chris Crespi and Lehman Brothers' Steve Levy, hold the view that paltry first-quarter spending levels hit the low-water mark for the year. And while Levy hedges it by saying that it's not clear spending has to go up, he doesn't think it will go any lower. The more bullish interpretation of his peers suggests that for the telcos to meet their full-year spending projections, buying must increase from here.

But to investors accustomed to hearing promises of a second-half bounceback in IT spending and similar largely unfulfilled prophecies, the glass-half-full view seems a little empty.

"That's crazy," says Dresdner's Mahler, who views the late-1990s spending binge as a mistake that will continue to take its toll on the gear suppliers for a long time to come. "We had unusually high demand based on ridiculous expectations related to network traffic models that were terrifically wrong."

It was notably evident on recent earnings conference calls that phone company executives have adopted a new attitude about spending. Keen to please investors and show they have a firm grip on the fiscal steering wheel, several executives promised to pull back on the spending lever to manage better cash flow. That is to say, the execs serve a far more significant constituency -- shareholders -- in cutting spending to the bone than they do in maintaining spending, by which they serve only their already weakened suppliers.

Sliding
Big telcos slashing spending

Source: Companies

In fact, SBC CEO Ed Whitacre told investors and analysts on a recent earnings call that he would "substantially beat" his lower spending target. Clearly a sign of which way some telco managers are leaning.

Crosstown Traffic

Supporting that trend, phone network engineers are telling analysts like Mahler and Communications Industry Research's Sam Greenholtz that they are finding more ways to reroute traffic and maximize their networks.

Though Verizon says rerouting has always been a part of traffic management, Greenholtz says the telco's engineers are under orders to spread the traffic over more pathways in order to

delay the need for costly network expansion.

Mahler has similar observations. "They're doing things like load balancing and moving traffic to different circuits," says Mahler. "It's not that difficult, and they can do it for a long time."

With no revenue growth in sight and only a mountain range of debts in front of them, it seems possible that telcos will be making do with less for a lot longer than gearmakers may want to consider.