Seeds of recovery sought in carrier capex numbers

Many optical communications companies this year have reported better numbers than last year. But whether real recovery is here for vendors of optical systems and components primarily depends on their customers: the carriers. Certainly, Verizon’s spending on FTTP has helped buoy the market. However, financial and market analysts say other carriers will have to follow suit if the recovery is to be sustained. And even then, not everyone will benefit. In fact, the optical-component space may continue to face a particularly trying future, they say.

“Our perspectives have kind of captured the idea that the recovery is being catalyzed by the competition between the cable companies, or MSOs [multiple systems operators], and the telcos,” says Simon Leopold, senior vice president and senior analyst at financial services firm Morgan Keegan (Memphis, TN). “Certainly, we’ve gotten announcements from the likes of Verizon on increasing their capital spending plans primarily in wireless but also in access technologies. In our view, a lot of that is stimulated by the pressure they’re feeling from cable guys putting out voice over IP as well as video services.”

Leopold notes that Time Warner added 242,000 VoIP customers in the quarter ending in June. “The interesting statistic that that correlates with is that Verizon’s access-line declines were the greatest we’ve seen since we’ve been tracking the data for over five years,” he says. Leopold put Verizon’s rate of decline at 6.7% year-over-year versus a rate of about 5% for other telephone companies.

The wireline erosion problem is becoming particularly acute, asserts Tom Hausken, director of the optical components practice at researcher Strategies Unlimited (Mountain View, CA). “The wireline business...is not only losing market share, it’s actually declining [in absolute numbers]. I mean, you can lose market share and not decline, but [this is] the worst possible scenario-it’s losing market share and declining.”

This scenario has led carriers to spend money to upgrade their networks to compete, with Verizon’s FTTP initiative a salient example. “Certainly, Verizon is putting its money where its mouth is, in the corporate sense, and spending on upgrading its access networks,” Leopold says. “I think there’s been a lot of skepticism from the investment community as to whether or not Verizon really meant it. Because in the past, going back into even the mid-1990s, carriers have talked about upgrading access networks and putting more bandwidth into the house-things like SBC’s Project Pronto-which didn’t really come about.”

As one of the founders of early PON pioneer Raynet, Drew Lanza, now a venture capitalist and general partner with Morgenthaler Ventures (Menlo Park, CA), has experienced first-hand the seemingly endless run up to optical access networks. “The way you know when it’s really coming is when the capex goes up, and in the case of Verizon, they’ve started to spend,” says Lanza. “I mean, to some extent, it’s what the RBOCs are spending that matters more than anything else.”

Verizon’s largesse has significantly improved life for several optical communications companies. “We just sold FONS [Fiber Optic Network Solutions] to ADC, and let’s just say that [FONS] had a surprisingly large amount of revenue-and they’re making the splitters and housings and a lot of the other passive infrastructure that needs to go in before you actually run fiber to homes,” Lanza reveals. “Based on the amount of revenue FONS had, Verizon’s pretty damn serious about this. So that’s real-that’s a real part of the recovery.”

“ADC actually reported a 30% sequential increase in sales in its April quarter this year, which is very unusual,” adds Leopold. “Not something you’d expect to be repeated, certainly, but evidence that Verizon’s spending is very strong and has ramped.”

Leopold projects “decent visibility” that Verizon is going to stay its FTTP course, which he says should serve to drive capital spending growth for the rest of this year. “I think the next question is to watch SBC,” he continues. “Because SBC really has not had any kind of an inflection point in its spending patterns and has announced its fiber to the node initiative as well as its fiber to the premises initiative. But we haven’t seen a lot of evidence that they’ve been spending on that. Certainly not the kind of patterns we’ve seen from Verizon.”

Leopold suggests that SBC’s lack of spending on its Project Pronto broadband initiative indicates that the carrier’s “track record of spending what they say they’re going to spend is not great” but concludes that competitive pressures from cable operators such as Comcast will compel the carrier to “become more aggressive” in its FTTX business.

Nevertheless, Leopold doesn’t foresee significant growth in carrier capex in the near-term. “The simple answer is, yes, capex should generally trend upwards,” he concludes. “However, I don’t think it will be huge growth rates; I’m not looking for double-digit percent growth rates.”

Yet, how carriers allocate their money could be more important to the optical communications industry than overall capex figures. For example, Leopold believes that much of Verizon’s FTTP initiative will be funded through the reallocation of dollars, as opposed to new dollars.

“I think some of the spending that Verizon’s been making on its FTTP initiative comes about simply because outside plant, a lot of the cables that they’re replacing with fiber or complementing with fiber, were due for maintenance,” he offers. “And so you can reallocate those maintenance dollars, call them growth dollars, and not spend, incrementally or significantly, more capex than you would have otherwise.”

Meaningful discussion of recovery requires that there’s a common understanding of what the term means. It appears that perceptions of the market remain colored by the boom at the turn of the century.

“I find sometimes people are extremely optimistic about telecom,” muses Strategies Unlimited’s Hausken. He believes that telecom can be likened to the airline industry; both are infrastructure-based industries with high capex and a perennial inclination toward economic cycles.

“It’s a little bit scary, because when you look at the airline industry…it’s always kind of hobbling along wounded,” Hausken cautions. “I could see the telecom industry doing exactly the same thing. My basic outlook on telecom is that it’s going to be slow but steady growth. It’s not going to be wild growth, ever again, and it’s not going to be terrible. But there is a scenario where you could get into the airline industry-type thing, where…one bankruptcy brings everybody down, another company comes out of bankruptcy, then somebody else goes down.”

“We’ll never see a real recovery,” asserts Lanza. “Well, I guess, ‘recovery’-that’s not fair to say; we’ll never see a boom again, you know? We did it. It’s done. Move on. But I’ve often said, we now know how to wire up the planet, we’re just getting on with it, right?”

If carrier spending continues to pick up, the systems vendors will benefit most. “I still think you can differentiate at the systems level, and you know, once you get a contract with a Verizon or even a large [municipal], it’s a cash cow,” says Lanza. “It’s the gift that keeps on giving.”

However, component vendors won’t reap the same rewards. “I happen to think the fiber to the home stuff isn’t such a great deal for optics people,” Hausken says. “It’s really the dirt cheap part of the business, and somebody will skid-sell something, but it’s really low margin, and they’re just beating up the suppliers, so it’s not like anybody’s going to make any money on that.”

“I have a number of investments in components companies too, and there the outlook is quite bleak,” agrees Lanza. “Here’s my belief: We will never come back to good times in the telecommunications components industry. There, at the bottom of the food chain, you’re under everybody’s boot. And so they’ll squeeze it out of you, man.”

In such a scenario, the long-anticipated consolidation of the optical-component space could finally occur. But even consolidation may not solve the problems faced by optical components.

“What could happen is, even as they go bankrupt, [those companies] never really go away,” Hausken theorizes. “They get chopped up, the intellectual property gets bought, somebody [else] ends up owning the plant. It doesn’t necessarily go into some completely different industry; it gets reused in the same industry, but now on a cheaper cost basis. This is the thing: Even a year from now in 2006, when some of these cash issues, you would think, would have to be resolved, I think it’s very likely that, yeah, they’ll get ‘resolved’ in a bankruptcy. But it still won’t be resolved.”

So it’s possible that happier days may be here again. But if these analysts are to be believed, not everyone will cheer up.

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