Monday, April 29, 2013

What Verizon Said About the Telco Industry

We are still early in earnings season but already there are signs that corporations have been affected by a sense of caution in the quarter. Of course these things are part and parcel of an uncertain political environment, and long term investors usually see them as decent buying opportunities. The problem with this approach is that when companies start reporting disappointments it will look similar to what they might say going into a protracted slowdown. So what to make of Verizon's (NYSE: VZ) latest results?

Irrational Melancholy

Investors had a right to be cautious going into these numbers. After all two leading tech companies had already warned of slowing spending by their telco customers. 

Firstly, Fortinet (NASDAQ: FTNT) warned that telco service providers were being cautious over closing deals in the quarter and, in particular over larger deals. On a more positive note, it argued that some customers were switching from a 'CapEx to OpEx’ spending mentality (so revenues might be more spread out in the future for Fortinet) and that the problems were not due to competitive losses. I also think there could have been an element of ‘pull forward’ in the previous quarter because Fortinet reported a very strong number of larger deals in the previous quarter.

Secondly, F5 Networks (NASDAQ: FFIV) also warned of a weak telco vertical. What is puzzling is that both companies reported decent enterprise spending. In the case of F5’s core application delivery controllers (a market that Fortinet has also recently entered by buying Coyote) telco carrier spending was far less than expected. Indeed, if you look at the details F5 reported strong numbers from telco customers in the previous quarter however, they did not follow through as planned in the last quarter.

Putting these things together, there are two scenarios that investors need to consider.

  • Is it the (bullish) case that there was a pull forward in telco spending at the year-end due to a budget flush effect, and all we are seeing now is a natural reaction to that which will get smoothed out in future quarters?

  • Alternatively, are the bears right and there is something unduly negative going on in the telco market causing a change of sentiment?

It’s time to look at what Verizon said.

Verizon Delivers a Mixed Prognosis

It is hard to give a definitive answer to the questions above. If it was easy then it would already be priced in!

On the bullish side the transition to newer technologies and services continues to accelerate at Verizon. The company started investing in 4G/LTE networks over five years ago and rolled out its network far quicker than AT&T (NYSE: T). It obviously has less need to invest now, and as the following graph demonstrates Verizon did its heavy lifting in next generation networks a few years ago while AT&T is playing catch-up.

Moreover, Verizon is seeing increasing penetration from smartphones (up to 61% from 58% at the end of the year), and given that 38% of the customers upgrading to a smartphone in the quarter were first-time users, the potential for rapidly increasing bandwidth utilization should be obvious. Verizon wants to do this. 4G/LTE smartphones already represent 40% of the smartphone total and 54% of its data is being carried on the 4G/LTE network.  As more customers upgrade it will drive growth at other carriers, and the pressure on the industry to spend on telco infrastructure must increase as a consequence.

On the bearish side Verizon spoke of ongoing caution among its enterprise customers. They still don’t appear keen on committing to capital spending, and the environment continues to be one of cost cutting first rather than investing for growth. Some sequester-related weakness in government spending was expected and it didn’t disappoint, but the ongoing caution among enterprises was a bit surprising.

Indeed, hopes of an upside to telco spending in 2013 still largely rest on Tier 1 carriers like AT&T investing in new networks as well as emerging market telcos starting to invest too. In my view the outlook for legacy telco spending has gotten a bit weaker recently with companies like Spirent disappointing with their legacy systems sales and noting that customers seemed minded to jump to higher bandwidth solutions.

The Bottom Line

In conclusion, the underlying trend of smartphone adoption and the proliferation of bandwidth-rich devices and applications continues apace. On the other hand, Verizon’s commentary continues to exercise a note of caution over enterprise spending and until it and AT&T talk of some sort of improvement there it would be churlish to conclude that happy days are here again for telco spending.

Those of us that think, and are invested in the telco spending theme, are left to sulk in the corner and wait for AT&T (which is expected to spend more this year) and others to report better things before going overweight on the idea.  It’s more jam tomorrow I’m afraid.

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