The Coming Year: Communications Networkers Must Live Up to the Hype

Cisco and Lucent, among others, are looking to build tomorrow's network.
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Communications-equipment makers such as Cisco (CSCO) - Get Report, Lucent (LU) and Ascend (ASND) - Get Report ended 1998 full of holiday cheer thanks to Wall Street's continued love affair with their stocks. This year, they'll have to prove they are worth their high premiums.

The top 10 builders of communication networks saw their shares swell by an average of 58% this year, even though their revenue ticked up only 14% and operating profits gained an average 4% in the four most recent quarters reported by each company.

Cisco's stock grew 150% even though the company increased revenue 34%; rival Lucent also added 175% to its market value as it posted 14% gains in revenue. Cisco trades at 101 times its profits for the past four quarters, and Lucent trades at 156 times trailing earnings. Ascend and

3Com

(COMS)

have also thrived lately, while laggard

Cabletron

(CS) - Get Report

appears to be in a tailspin as losses mount.

"The haves are gonna have a lot more, and the have-nots are gonna have a lot less," says Craig Johnson, principal with the

Pita Group

consulting firm in Portland, Ore. Johnson estimates that the 10 major players in communications equipment will grow revenue roughly 20% to 25% in 1999. Not so with the smaller guys.

In 1999, all eyes will once again turn to Cisco and Lucent, the two dominant players in this sector. Cisco, for its part, has firmed its foundation in the business of tying corporations to the Internet. There is little sign that corporations have slowed their capital spending, which bodes well for Santa Clara, Calif.-based Cisco. This year's formidable task is to work on making the Internet reliable enough to carry telephone calls without a loss in quality. On the other hand, Lucent, a longtime supplier of equipment to phone companies, needs to improve its Internet applications. Optimism about the move of telephone systems onto the Internet partly explains why investors are pushing stocks so high.

But even bulls advise caution.

"Before we join hands to usher in this 'golden age of networking' when all media

including telephone, data, television, radio, photography, fax, etc. converge into a single integrated network, there are some technical issues to be resolved," wrote

J.P. Morgan

analyst Bill Rabin in a recent report titled "The Secret Sauce of Convergence."

The good news for equipment builders is that network carriers are investing serious money today in tomorrow's network. Long-distance carrier

Sprint

(FON)

hired Cisco to help construct its ION network, designed to integrate voice and data messages, and expects to activate initial ION services in mid-1999. Next year, the

Baby Bells

will increase their capital spending on data networks 25% to 30%, according to estimates from analyst Tim Savageaux with San Francisco-based investment bank

Volpe Brown Whelan

. Revenue from data services is growing at about a 35% clip, Savageaux says.

Conversion of voice and data could be a win-win situation for both companies. Cisco and its peers understand more fully just how computer networks are stitched together, and they pounce quickly on changes in customer demand, according to Rabin. Lucent and Canadian telecom-gear maker

Nortel

(NT)

, for their part, have expertise in the arcane signaling controls for telephone calls -- which must be layered onto the "converged" network of tomorrow.

Investors continue to pour money into Cisco stock. "It is expensive by any stretch of the imagination," Rabin says. But he will not downgrade Cisco, by all checks a strong company, just because it's pricey. "I have trouble being negative if the market is overly optimistic."

Carriers are the focus because of a fundamental change in the networking world. Corporations are demanding rebates from networkers competing for their business. Market tracker

Dell'Oro Group

estimates that prices for local networks will fall an average 9% in 1999, after falling 7% last year.

Competition is still tightening, mostly to the detriment of smaller players. Cabletron's sales and profits have continued to grow weaker; after bolting to the sky,

Ciena

(CIEN) - Get Report

lost critical business contracts and was left at the altar by

Tellabs

(TLAB)

. Next year, nimble start-ups such as

Juniper Network

and

Terayon

intend to challenge Cisco with their routers. But for the time being, Cisco, Ascend, 3Com, Lucent and Nortel have planted firm feet in most of the networking yard.

J.P. Morgan's Rabin expects more consolidation. Driving this trend is the need for carriers to procure products from just a few vendors with worldwide reach. For example, in order to gird for the battle of convergence, phone-gear supplier Nortel acquired

Bay Networks

in late summer.

"The combined market will be dominated by four or five giant equipment vendors, each offering a full set of products and services, while mid-cap and small-cap companies will probably either be acquired or crushed by the competition," he says.