Worm is Turning!
Forget Oil. Buy Telecom. See Motley Fool.
The telecom equipment makers have been suffering because of the tremendous overcapacity that resulted from huge investments back in the bubble days. Ever since the bubble popped, these companies have been struggling to right their businesses in the face of plummeting revenues and gross margins. But most of these companies raised so much money during the bubble that too many of them have been able to avoid going out of business. That has stalled the prospects for a recovery in the industry. As a result, investors have left for dead many of the companies, notably those involved in fiber-optic communications.
The skinny
Network capacity is not as large as widely believed. According to TeleGeography, an organization that tracks the communications industry, worldwide Internet traffic is growing by 115% per year. In addition, a recent column in The Wall Street Journal reported that the 10-year growth rate in Internet traffic is quoted as being 75% per year. Of course, there is no guarantee that the growth rate will remain at these levels, but I believe it's unlikely that the growth will suddenly crater far below the 10-year average.
The catch is that if the growth rate stays near the 10-year average, all of the currently available capacity on long-haul networks will be consumed within two years or so. You'd expect that telecom companies would start adding capacity a year or so ahead of that time to avoid bad service. And while the TeleGeography data tells us that network equipment spending should increase soon, there is evidence that the increase has already begun.
If the Laser Focus World survey is correct, we should see proof of it in the revenue growth of companies that make lasers and other networking equipment. Well, after several tough years, revenues for many of these companies, including ADC Telecom and Ciena, did grow slightly in 2004.
What is driving the growth?
One of the big growth drivers is fiber-to-the-premises (FTTP). If you send an email from a coffeehouse in San Francisco to a friend in New York, that email will be transmitted across the country through optical fibers. But the final mile or so to your friend's apartment is probably handled by an old-fashioned copper-wire network. Running optical fiber all the way to your front door will allow for delivery of the "triple play" of high-speed Internet, video, and phone service over the same fiber-optic cable.
Verizon and SBC have both committed to large FTTP deployments by promising to extend fiber to millions of their customers. FTTP should be beneficial for equipment providers because a lot of electronics, optics, and connectors will be required to bring fiber to our doorsteps. This will have the ancillary benefit of increasing overall traffic on the long-haul routes (though at a moderated pace) that are responsible for carrying data over long distances. As a result, some of the unused fiber on these routes will have to be gradually put in service, or "lit up." To make unused fiber active, telecom providers will be forced to buy equipment for both ends of the fiber.
By increasing traffic on the long-haul routes, FTTP will drive additional investment there, as well as equipment to regenerate and amplify the signal periodically as it makes its trip.
But even though demand for networking equipment is likely to increase, it may not fill all of the network equipment makers' sails. Remember, there's a lot of capacity left over from the bubble. There are still too many companies making the lasers that transmit signals down the optical fiber, for example, so some of these companies are likely to go away unless the demand increase is huge. I would consider only the companies that seem to have a low valuation, are able to maintain reasonable gross margins, and are at least close to being profitable.
Forget Oil. Buy Telecom. See Motley Fool.
The telecom equipment makers have been suffering because of the tremendous overcapacity that resulted from huge investments back in the bubble days. Ever since the bubble popped, these companies have been struggling to right their businesses in the face of plummeting revenues and gross margins. But most of these companies raised so much money during the bubble that too many of them have been able to avoid going out of business. That has stalled the prospects for a recovery in the industry. As a result, investors have left for dead many of the companies, notably those involved in fiber-optic communications.
The skinny
Network capacity is not as large as widely believed. According to TeleGeography, an organization that tracks the communications industry, worldwide Internet traffic is growing by 115% per year. In addition, a recent column in The Wall Street Journal reported that the 10-year growth rate in Internet traffic is quoted as being 75% per year. Of course, there is no guarantee that the growth rate will remain at these levels, but I believe it's unlikely that the growth will suddenly crater far below the 10-year average.
The catch is that if the growth rate stays near the 10-year average, all of the currently available capacity on long-haul networks will be consumed within two years or so. You'd expect that telecom companies would start adding capacity a year or so ahead of that time to avoid bad service. And while the TeleGeography data tells us that network equipment spending should increase soon, there is evidence that the increase has already begun.
If the Laser Focus World survey is correct, we should see proof of it in the revenue growth of companies that make lasers and other networking equipment. Well, after several tough years, revenues for many of these companies, including ADC Telecom and Ciena, did grow slightly in 2004.
What is driving the growth?
One of the big growth drivers is fiber-to-the-premises (FTTP). If you send an email from a coffeehouse in San Francisco to a friend in New York, that email will be transmitted across the country through optical fibers. But the final mile or so to your friend's apartment is probably handled by an old-fashioned copper-wire network. Running optical fiber all the way to your front door will allow for delivery of the "triple play" of high-speed Internet, video, and phone service over the same fiber-optic cable.
Verizon and SBC have both committed to large FTTP deployments by promising to extend fiber to millions of their customers. FTTP should be beneficial for equipment providers because a lot of electronics, optics, and connectors will be required to bring fiber to our doorsteps. This will have the ancillary benefit of increasing overall traffic on the long-haul routes (though at a moderated pace) that are responsible for carrying data over long distances. As a result, some of the unused fiber on these routes will have to be gradually put in service, or "lit up." To make unused fiber active, telecom providers will be forced to buy equipment for both ends of the fiber.
By increasing traffic on the long-haul routes, FTTP will drive additional investment there, as well as equipment to regenerate and amplify the signal periodically as it makes its trip.
But even though demand for networking equipment is likely to increase, it may not fill all of the network equipment makers' sails. Remember, there's a lot of capacity left over from the bubble. There are still too many companies making the lasers that transmit signals down the optical fiber, for example, so some of these companies are likely to go away unless the demand increase is huge. I would consider only the companies that seem to have a low valuation, are able to maintain reasonable gross margins, and are at least close to being profitable.
