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WorldCom Downgrade Offers More Evidence of Telecom Spending Slowdown

A Lehman analyst says capital spending can't maintain its recent rate of acceleration.

Wednesday brought more evidence of a coming slump in communications-equipment spending, in the form of a

WorldCom

(WCOM)

downgrade.

Lehman Brothers

telecommunications-services analyst Blake Bath Wednesday cut the lagging stock to outperform from buy, citing a long-distance telephone revenue slowdown in the face of sharply rising industrywide capital spending. The resulting earnings slump will force WorldCom and its competitors to cut back on spending, the analyst suggested.

The news isn't bad only for the big telecoms, though it was plenty bad for WorldCom, which lost 6% Wednesday. A pullback by the biggest spenders on telecom equipment could easily ripple through the networking sector, where shares have rocketed in the last year as investors rallied around the accelerating global network buildout. With the entire sector, from

Cisco

(CSCO) - Get Report

on down, seemingly priced for perfection, any slowdown could result in a big pullback in networking shares.

Unsustainable?

According to the Lehman report, the telecom-services industry next year will spend one dollar on capital equipment for every two dollars it generates in revenue. That marks a dramatic increase from 1996's 1:5 ratio, and this year's 1:3.

While at first blush this rising tide of spending seems like good news for the equipment sector, Bath calls the 1:2 ratio unsustainable. With competitive pressures rising and long-distance revenue dropping, big-spending telecom companies such as WorldCom,

AT&T

(T) - Get Report

and

Sprint

inevitably will have to cut back on capital spending. Those decisions are likely to undercut the heretofore insatiable demand for telecom-networking gear, punishing the stocks that have benefited from that demand.

WorldCom didn't have an immediate comment. Lehman advised the Jackson, Miss., company on its merger with MCI.

Other Issues

The spending pullback isn't the only problem for the networkers and the small network builders they often serve. Also complicating matters, in a number of ways, are the weak share prices of most telecom-service companies. And, just as the companies' interlocking relationships -- as supplier and customer, shareholder and financier -- mutually boosted their fortunes in sunny times, a shakeout could lead to a vicious wave of selling.

WorldCom, for instance, isn't alone among giant telecom outfits in trading at recent lows. Sprint,

SBC Communications

(SBC)

and

Verizon

(VZ) - Get Report

are all trading at 1998 levels, and AT&T has actually fallen to a price last seen in 1997.

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To address their weak share prices, these companies have either created or planned to create tracking stocks that give investors a chance to benefit from their fast-growing units. These units operate in sexier areas of telecommunications, such as wireless and data services.

As the large, established phone companies cut themselves up, the smaller start-up telcos do the bleeding.

Bath estimates the megacap telcos will create some $60 billion worth of tracking stocks or carveouts over the next six months. That's $60 billion that won't fund new companies because, as these spinoff shares flood the market, fewer dollars will shake down to the new network builders.

The Ice Age

As

TheStreet.com

examined two weeks ago, new network builders such as

Williams Communications

(WCG) - Get Report

have already begun to feel the

funding squeeze. Williams is $1 billion short of its capital-spending budget. With its shares trading below their IPO level and the company having recently tapped the junk bond market, Williams found it needed to take the extraordinary measure of selling part of its portfolio of networking investments to pay for new equipment and network expansion.

The Williams situation serves as a warning for the market's current darling, the red-hot optical-networking sector. New network builders are the prime customers of the new network-equipment vendors, such as

Sycamore

(SCMR)

,

Ciena

(CIEN) - Get Report

,

Corvis

(CORV) - Get Report

and

ONI

(ONIS)

. They are also, in Williams' and

Broadwing's

(BRW)

case,

investors in these companies.

To be sure, spending projections continue to be strong. But as more evidence of a cooling trend streams in, a wildly optimistic outlook and incredibly rich networking company valuations will be harder to sustain.