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Cody Willard

The Domino Effect: The Fragile State Of The Telecom Industry

BY CODY WILLARD


None of us should be surprised by the current spate of pre-announcements and low visibility reported by the telecom equipment vendors and component suppliers. The intricacies and intertwining of the telecom sector is really quite straightforward. Thus, when the CLECs (Competitive Local Exchange Carriers) began to experience cash problems, and the long distance providers began to talk about slowing revenue growth and lowered capital expenditures, it follows that the vendors and their suppliers would soon begin to see erosion in their business models as well.

It was a little more than a year ago when DSL (Digital Subscriber Line) CLECs like Covad, Rhythms, and NorthPoint began their long, slow descent to becoming penny stocks. Fixed wireless providers, Winstar, Teligent, and Advanced Radio Telecom also peaked about the same time. The CLEC environment hysteria was capped when BLECs (Building Local Exchange Carriers) like Allied Riser and Cypress Communications held successful IPOs (Initial Public Offerings). However, over the past twelve months, all these companies' shares have dropped so precipitously that any hopes of tapping the equity markets for additional funding have pretty much disappeared. Likewise, the yield on their debt has risen dramatically, as bond holders have become leery of their chances of being paid back, thus leaving these companies strapped for additional capital.

The capital problems were not exclusive to the access side of the network. Indeed, over the last year, the upstart long haul overbuilders like Level 3 and 360networks began to see their access to capital dwindle in much the same way the CLECs did. At the same time, entrenched long distance providers started to feel the crunch on their growth projections as the upstart overbuilders began to steal market share and undercut standard pricing models. When their top line growth began to fall, the entrenched long distance providers like WorldCom and Sprint began to cut back on capital expenditures to try and shield their bottom lines from the same contraction.

The questions we all should have been asking ourselves as this fallout began to gain momentum was this: What do these companies buy with this capital, and from whom do they buy it?

The service providers need the money to buy things like switches, routers, and other telecom equipment. Naturally, the makers of this equipment have benefited enormously from supplying the network build outs. Now, however, with funding for service providers drying up, these equipment makers have really began to feel the squeeze. Companies like Lucent, Cisco, Extreme, Foundry, and Terayon have found themselves in a world of hurt, as the demand for their products has collapsed. Their problems, in many cases, are magnified because many of them provided the money for these upstarts to buy their equipment on favorable terms (vendor financing).

In general, these large orders from so many companies vying to provide voice, data, and Internet services created huge demand for the equipment vendors' products. The demand drove prices higher and the vendors enjoyed fat margins and couldn't build their switches, routers, and other equipment fast enough. But just as they started to get their production in line with demand, orders were scaled back or cancelled entirely. Consequently, inventories grew, and as a next step in the logical supply chain, we should have asked ourselves: What components go into these switches and routers, and who supplies the equipment vendors with these necessary components?

Just as equipments vendors felt the squeeze from CLECS, the component suppliers were the next domino to fall in the telecom industry. Chip makers like PMC-Sierra and Applied Micro Circuits Corporation (AMCC) or laser suppliers like JDS Uniphase have all seen their inventories grow while their sales decrease. Also, photonic processor manufacturers like Avanex and amplifier suppliers like New Focus are all experiencing the same trend. These component suppliers' inventories are now growing, because they have no visibility into the size or number of future orders. Accordingly, these companies have been guiding their revenue and earnings estimates downward.

As the weaker service providers begin to fold operations -- as we're beginning to see many of them do -- the stronger ones will become stronger. Demand for bandwidth continues unabated and will accelerate as higher access speeds become reality though development like fiber to the home and free-space optics. Such successes for the survivors will again drive their demand for equipment which will in turn drive demand for components. The glut of used equipment could delay the onset of new demand, but eventually, the vicious cycle of today will again become a virtuous cycle of tomorrow.

Cody Willard is senior telecom and Internet infrastructure analyst at Visual Radio LLC, an advanced communications development company. He is also founder and president of Teleconomist.com, a Web site devoted to news and analysis of telecommunications stocks. He was formerly a partner at the Lanyi Research Division of CIBC World Markets. Cody appreciates your feedback and invites you to send it to clwillard@teleconomist.com.







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