May 2004

Equipped For The Future

BY PHIL ASMUNDSON

It�s been a rough few years for telecom equipment manufacturers, especially when you consider the sonic boom of the �90s, during which companies were spurred to purchase equipment and upgrade their infrastructure in anticipation of increased demand in network traffic. Credit the initial explosion to the Telecommunications Act of 1996, which unleashed industry competition. That, combined with the commercial takeoff of the Internet and subsequent �new economy� mindset, encouraged massive infusions of capital into new, inexperienced companies. With increased investment in telecom equipment, economic growth swelled, which, in turn, stimulated more investment. The new economy mantra was to acquire customers, grow revenue, and capture market share at almost any cost since the appetite for bandwidth was �insatiable.� Spending on equipment and software in those heady days, in the United States alone, leapt from $146 billion in 1999 to $174 billion in 2000.

Then the party abruptly ended and the hangover began. With the contraction of the economy and intensified competition, new companies could no longer rely on external funding from VCs and vendors. And, to their surprise, they found that their cost structures were too high. The dot-com boom started the equipment build-up. As the dot-coms faded away, network traffic growth slowed, creating excess capacity. Then there was the contributing factor of bad timing. Companies that had invested in new equipment to ward off potential Y2K problems stopped making new purchases. And the economic downturn caused everyone to rethink capital spending. The scene wasn�t helped by the decline in the network gear market, thanks to bankruptcies by a number of competitive local exchange carriers. High flyers like Lucent, Nortel, and Alcatel lost 99 percent of their market value and are a quarter of their peak sizes in terms of employees. According to the Telecommunications Industry Association (TIA), spending on all telecom equipment has fallen by a combined 24 percent over the past two years.

BOTTOMED OUT
But now it looks like the tide may be turning, albeit slowly. Troubled Lucent, for example, announced disappointing third-quarter earnings, but also a three-year deal worth up to $1 billion with Sprint to update Sprint�s high-speed wireless network in the United States. Lucent CEO Patricia Russo is publicly stating that she expects the company to return to profitability in fiscal 2004, although it is a delay from her earlier projections regarding Lucent�s profitability.

�To a large extent, I think they�ve [telecom equipment companies] at least hit the bottom and that�s a good thing,� says Gene Monacelli, national telecommunications partner for Deloitte & Touche�s TMT Group. �There was a time when no one knew where the bottom was. It�s started to stabilize because customer segments have normalized.�

Part of the problem was that equipment providers had become dependent on emerging companies as a customer base. When that base dried up, they had to return to their traditional customers. That move has shifted the focus to a more stable customer base. But how do equipment providers create growth in a smaller business space with customers that have reduced their spending?
There are several scenarios being played out that may well answer that question in ways that will please investors. �We believe we�re at the bottom, but we�ll be seeing single-digit growth in the next several years,� notes Matthew Flanigan, TIA�s president.

In fact, Gartner projects that worldwide telecom equipment spending will grow a modest 4.4 percent (compound annual growth rate) from $273 billion in 2002 to $310 billion in 2006.

THE IP DRIVER & OTHER DEVELOPMENTS
One opening for telecom equipment companies is the migration to IP telephony from PBX systems. Some are waiting until its benefits are better understood. �It�s still a relatively new technology. It�s primarily been early adopters who have made the transition to this technology, says Gartner principal analyst Drew Kraus. �Late adopters are still waiting to see if it�s solid and scalable to larger organizations, so they�ve been delaying their decisions until they�re certain that the technology has solidified and matured.�

Frank Stinson, program director for Infotech, believes that some growth will be driven by IP telephony because vendors are talking up financial savings and improved productivity. �Manufacturers like Cisco have a converged platform that allows customers to use some of their current hardware, which is easing the transition,� says Stinson.

But, he says, it�s important to remember that by 2005, we�ll be out six years from the late �90s and, �we�ll be back to churn. Companies can fully depreciate their systems in that time frame and will have budgeted in their long-term plans to purchase new systems.�

Another driver may be 3G (the specification for mobile communications technology) and other wireless technologies. Flanigan believes that the rest of this year will show a slight improvement, but that starting in 2004, the wireless arena will take off again because 3G phones will hit the market, providing voice, video, and data services that will require �some nice equipment purchases in �04.�
Still another reason experts anticipate increased spending has to do with a new FCC broadband policy that was announced in February 2003. The new policy relieves telephone companies of the requirement to share their broadband networks with competitors.

�This is an important part of the puzzle,� says Flanigan. �It frees up BellSouth, Verizon and SBC Communications to compete against cable companies in broadband and they�ll have to start making investments to get back that market.� He notes that Alcatel and Westell among others have seen large increases in orders for DSL from Bell operating companies.

And then there�s government spending. A report issued in June 2003 by market research firm Input, predicts that spending by the U.S. Department of Homeland Security will increase 11 percent compounded annually on telecom and networking wares and services through 2008. Input anticipates Department spending of $623 million on telecom in 2003 to increase to $1.05 billion in 2008. The firm, however, does note that equipment is the smallest portion of that market overall, with $48 million in 2003, growing to $81 million in 2008. The majority of spending is on network services and professional services. Overall federal telecom government expenditures could reach $17.3 billion during the next five years, says Input�s manager of customer care, Brian Haney.

Finally, the existing last-mile infrastructure may be insufficient for delivering real results. Verizon recently announced a $10 billion fiber-to-the-premise project. Verizon�s plans indicate that an entirely new last mile solution with infinite bandwidth may be the only real long term solution. Couple Verizon�s announcement with the fact that most of the major ILECs (incumbent local exchange carriers) and IXCs (inter-exchange carriers) recently agreed to an optical standard, and you have the capability to deploy fiber end-to-end. It would be a complicated and costly undertaking, and it puts the cable operators and telcos in the ring. If this last-mile solution is rolled, it will also devour the excess capacity in the core, which will help stabilize prices over the long run.

MOVING TOWARD MODULARITY
One of the louder voices in this discussion of telecom equipment recovery belongs to Anthony Ambrose of Intel. The general manager of marketing and platform programs for the company�s Network Processing Group, Ambrose spoke on the concept of modularity at a recent trade show.

Ambrose suggests modularity, not proprietary systems, will define the future for the telecom industry. �Modularity is more than open standards,� he explains. �It�s how open standards are delivered. What�s different is a standard set of interfaces within the gear itself � a standard set of hardware that defines how hardware is built, standard carrier-grade operating systems, standard middleware.�

This approach could lower carriers� acquisition costs for new equipment as well as ongoing operational costs. �They�ll be able to take advantage of better equipment using less power, less real estate and economies of scale in service and support,� he adds. �Additionally, modularity enables new applications to be deployed more quickly since they�ll be deployed on top of already understood hardware and specifications. That will fuel more new applications and services that, in turn, fuel faster revenue growth.�

Customized solutions create a lot of financial pressure and set different expectations of the customer. Modularity says that�s ridiculous. It�s not sustainable and the reality is that most of this should be plug and play. What are the effects of standardization in terms of organization and structure? It drives costs out of the business. And, for the manufacturer, the more mass production, the more standardized parts one can use, the easier it is to sell.

The shift away from proprietary systems has been spurred by the convergence of voice and data, according to Mike Durance, vice president and general manager for Toshiba�s Telecommunications Systems Division. �Networks are converging, the infrastructure within networks is converging, and IP has been a great enabler and facilitator of that,� he says.

Ambrose points out that Intel, HP, and Alcatel have been modularity advocates for a couple of years now and are at the point of putting products on the market based on this concept.

�We�re entering into a collaborative model with almost all network equipment providers. We�re helping to move them into an infrastructure with Linux technology embedded in network equipment,� says Marco Limena, vice president and general manager of the solution organization in HP�s Network Service Provider unit.

 ï¿½We�re also working with Intel to push a flexible infrastructure that allows providers to deploy technology at lower costs.�

Some question how modularity and open standards will enable equipment makers to differentiate themselves, but Durance notes that there is tremendous potential for differentiation. �We�re migrating our solution to full IP on an open server, and one of our opportunities is to support open standards but allow our sets to integrate more fully and enhance their value. Ultimately, applications will operate much better interfacing with our switch,� he says.

FROM MANUFACTURING TO SERVICES
Another strategy afoot is for equipment providers to enter the service business. �Who better than the manufacturers to provide the services?� Flanigan asks.
Lucent and HP have developed service channels. Toshiba, too, is thinking about this as a new business, says Durance. The company recently created an Integrated Software Services (ISS) group to develop custom software solutions for their customers. �It goes back to modularity,� he explains. �There�s a move to open standards, yet end users want a solution and as much return on investment as they ever have. It�s an interesting point in telecom history. There�s a lot of complexity with the opportunity to blend different kinds of media together through IP. The challenge to equipment providers is to simplify it and create flexible solutions. In an IP environment, with so much complexity and so many new applications, ultimately there�s a need to deploy services around that for enterprises to get the most out of their systems.�

Kraus wonders if accessing telephony functionality through a service provider instead of owning the equipment outright is feasible. �Few went for it because it was expensive, under-featured, and slow to adapt new technologies,� he explains. �But because the server can now be removed from the infrastructure and located anywhere, it could be located at a service provider�s site. All the customer would have to do is enter through a Web interface to make changes to the system, as though the system were in their own telecom closet.�

However the telecom equipment companies move forward, industry advocates like Flanigan are convinced that the tide finally has turned. �Telecom is so critical to every business. More and more information is being transmitted as data. We see that there will be an increase in capital expenditures once again,� he says.

Phil Asmundson is Deputy Managing Partner for Deloitte & Touche�s Technology, Media, & Telecommunications (TMT) Group. The Technology, Media & Telecom-munications (TMT) Group has deep industry knowledge of technology, media, and telecommunications companies and the challenges these industries face in areas such as Internet, software, computers, telecommunications and networking, semiconductor and related industries, along with broadcasting and publishing. For more information, visit www.deloitte.com.

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