Bottom line looks better from the bottom

The more companies we meet these days, the more we see a consensus that the communications market is bumping along the bottom. At the same time, the many management teams we have talked with express growing confidence that they have a handle on costs. Even if business activity were to ratchet down a notch, these management teams are willing to make moves that will keep the cost picture and thus the bottom line headed in the right direction. Despite this improved picture, no one is expecting a consequential rebound in revenues over the balance of this year or even next.

That raises an obvious question: Since they didn't see the scope of the decline, how can they comprehend the magnitude of a recovery? While it is highly likely that carriers, system vendors, and component suppliers will overshoot their capacity corrections, for a brief period of time when business spending finally turns, there will be plenty of people and facilities as well as excess capital equipment that can be brought back fairly quickly. So it does not strike us that the caution is without good foundation.

Add to that the six-fold increase in venture funding of new communications and networking technologies from 1998 through 2000, compared to the previous three-year period; what's left is an overhanging inventory of system and component advances that can be resurrected to cure any bottleneck that arises as demand improves. While the watershed may have arrived when it comes to startups closing their doors, much of what is perceived to be valuable intellectual property is being warehoused in various places, ready to reemerge when it once again has a perceived value.

Also striking is that the solutions available to service providers are so much better today that they don't need nearly as many boxes to keep pace with fairly heady traffic growth. Furthermore, during the downturn, the newer generation of equipment had a chance to prove itself, and by in large it was a success story. To oversimplify the situation, what service providers found when they had the time to evaluate many of the new platforms was that they truly delivered against the claims of three to four times the throughput in one-fourth to one-third the footprint. In addition, most of the new platforms were more flexible to work with than older classes of equipment, and they offered other operational-expense efficiencies.

Those factors add up to good news for carriers and their customers looking ahead, but broadly defined, they do not represent good news for the communications equipment business and its suppliers. The story for those companies is likely to be an uphill battle of selling a lesser number of cheaper machines to support growing network traffic requirements. It is a tough formula for growth. When the perception was one of traffic growth at unimaginable rates for a protracted period of time, it felt like a manageable problem. We now know those impressions were built partly on falsehoods, a unique confluence of events, and our own hubris stemming from what we were all seeing in our businesses in the short run.

While we paint a bleak picture, our comments are focused on the industry as we know it today. Recoveries are most often built around new waves of technology. In addition, modest-sized companies that are highly exposed to the current generation of communications technology and unexposed to legacy businesses may do very well, particularly where they do not face a debt-burdened capital structure that demands they generate billions of dollars in annual sales to meet existing obligations. Even in some of those instances, if management takes advantage of the early stage of a recovery to redefine its future opportunity, they may have a chance at a profitable future.

Many companies that managed to navigate the business debacle of 2001 up to this time will not manage to survive the next cyclical decline. The fact that everyone went so far overboard in preparing for growth up to the downturn created a monstrous cushion to cut costs to reach the more sound footing they have today. Any further cuts will be tougher to come by.

The right course of action will be more widespread consolidation than the downturn has produced. Consolidation can take different forms ranging from the sale of whole companies to the elimination or sale of product lines. Business combinations are not easy in any economic climate, but certainly an expanding market provides more wiggle room to manage through the unexpected.

The early stages of a recovery when investors do not fully comprehend the full extent of cost-saving strategies that have been implemented will be an easier time to make these moves. Time will show that those who predicted major consolidation among today's industry players were correct—they were just a little early in their prediction.

One of the more gratifying things we have done recently is to stop in on a few early-stage companies that we had overlooked the past year because of the weak spending climate, diminished travel, and obviously very few companies have been planning to go public. It's nice to find there are a number of companies doing well, getting incremental funding, and that seem like legitimate IPO prospects.

Kevin Slocum is a managing director in investment banking at SoundView Technology Group (Greenwich, CT). He has more than 20 years of financial industry experience, including institutional equity research sales and analysis, and has been named to the Wall Street Journal's prestigious "Home Run Hitter" list two consecutive years. He can be reached at 203-321-7200 or kslocum@soundview.com.

SOUNDVIEW CONFLICTS Important information about SoundView's conflicts can be found at www.soundview.com/Research/ConflictDisclosure.

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