|Equipment makers face long recovery|
By Jeffry Bartash, CBS.MarketWatch.com
Last Update: 4:33 AM ET Jun 2, 2001
WASHINGTON (CBS.MW) -- There used to be a saying on Wall Street that when a war breaks out, investors ought to buy the "arms dealers."
They're not saying that anymore when it comes to manufacturers of telecommunications equipment. And it may be a long time again before they do.
Manufacturers, of course, are already reeling from an industrywide sales slump. What's worse, equipment companies have lost much of their ability to control prices. They've ceded that power to their primary customers, the phone carriers.
Until they regain that power -- when they do is anyone's guess -- profit margins are likely to remain under siege and stock prices under pressure.
An examination of recently issued government data paints a dismal picture of the equipment sector.
From April 2000 to April 2001, shipments of communications equipment sank 23.3 percent, according to the Commerce Department. Even worse, new orders plummeted a whopping 37.5 percent, with most of the decline in the last six months.
Granted, those declines appear to have slowed in the past few months. Nonetheless, the implication is clear. Orders aren't going to rebound anytime soon.
Indeed, none other than Federal Reserve Chairman Alan Greenspan, who follows the high-tech sector closely, predicts that the equipment industry still has a long way to go before it regains its health.
"Inventories of semiconductors and computers have fallen, but less progress appears to have been made with respect to communications equipment," Greenspan said in a speech last week. A "period of substantial liquidation still appears ahead for these products."
Most industry observers agree. For instance, Morgan Stanley analyst Alkesh Shah on Tuesday downgraded a handful of equipment stocks, such as Nortel Networks (NT), Tellabs (TLAB) and JDS Uniphase (JDSU), on concerns that a turnaround won't start until the fourth quarter at the earliest.
Similarly, market researcher RHK is set to issue a report on Monday predicting that worldwide sales of small components used in larger optical products or networks will decline in 2001. RHK also cites excessive inventories. Growth won't resume, the firm said, until next year -- and even then it won't be very strong.
Said Bruce Hyman, an analyst at debt-rating agency Standard & Poor's: "We're thoroughly concerned about the overall market for telecom equipment."
Root of problem
The current communications breakdown wasn't supposed to happen, of course. With the Internet spawning huge demand for new telecom services, communications carriers were expected to keep spending on the latest technology to upgrade their networks.
The emergence of hundreds of new local, long distance and Internet service providers only fueled competition and triggered an equipment "arms race." New carriers sought to build state-of-the-art networks, forcing old line industry giants to play catch up.
For several years, investors made a killing by socking cash into the stocks of equipment makers. Even if stiff competition caused profits of phone carriers to fall, the thinking went, equipment makers would still make out. Carriers would have to spend to satisfy data-hungry customers and keep ahead of the competition.
The theory worked fine until the stock market turned south in spring 2000. The problem quickly became clear. There were too many carriers chasing too little revenue. Something had to give -- and that meant a slew of carrier bankruptcies and failures.
"The market funded a lot more competition than the market could sustain," said William Kennard, former chairman of the Federal Communications Commission, at an industry gathering earlier this month.
Slackened competition naturally bodes well for the carriers that survive the current shakeout. More important, it gives them significant leverage over their suppliers, the equipment makers.
For one thing, phone companies are slashing capital expenditures. When they do buy new equipment, they don't necessarily have to go straight to the equipment vendors, either. With so many smaller phone carriers going belly up, lots of barely used switches, routers and other gear can be obtained for pennies on the dollar in auctions.
Indeed, the industry's even buzzing with talk that the big equipment makers themselves are buying some of the used products and destroying them, minimizing distressed-auction sales as a form of competition.
Nevertheless, the fact remains that equipment vendors are now fiercely competing for a smaller pool of customers and orders. Most have cut prices in an effort to gain or maintain market share.
Earlier this month, Ciena Chief Executive Gary Smith asserted that "desperate" rivals were trying to seize business from his company by chopping prices. Ciena (CIEN) has been one of the few vendors whose sales have sharply increased this year.
The carriers, in turn, are playing equipment makers off against each other in search of the lowest prices. Only companies such as Ciena that make unique optical systems or other crucial gear have retained some control over pricing.
The turmoil in the equipment industry, in fact, is what analysts believe stoked serious merger talks between Alcatel (ALA) and Lucent Technologies (LU). Though those talks collapsed this week, the prevailing view is that more vendors will have to team up to survive the downturn.
Of course, dwindling stock prices and shaky finances make acquisitions very difficult these days. If lots of deals do happen, they'll probably have to be more like true mergers. That means little or no premium for shareholders.
For now, investors probably should steer clear of the equipment sector. Until the phone carriers move en masse to the next generation of weaponry, the "arms dealers" are going to be busily engaged in a war of their own. Expect casualties.
Jeffry Bartash is a reporter for CBS.MarketWatch.com in Washington.