Monday, August 20, 2012

When Will the Telco's Start Investing Again?

There are few industries that are less cyclical than the telecom industry. At the top of the pyramid lie the service providers like Verizon (NYSE: VZ) and AT & T (NYSE: T). Their capex plans ultimately drop into the top lines of the equipment providers like Cisco Systems (NASDAQ: CSCO), Alcatel-Lucent or Ciena and then down to the switches and components manufacturers like Finisar (NASDAQ: FNSR) and its chief rival JDS Uniphase (NASDAQ: JDSU).

It was Finisar’s turn on Monday to report numbers and from the results plus commentary, it’s clear that the story is still one of jam tomorrow. So when can we expect the Telcos to start spending and get the cycle going again?

There a few separate answers to this question. Before going into them, it is worth looking at how long this weakness has been persisting. We can see this in Finisar’s Telecom revenues below.

After a strong 2011, it has now been four quarters in a row that Finisar’s telecom revenues are lower on a yearly basis.

What is Happening in Telco Spending?

Telco capex spending tends to be long cycle and involve a significant financial commitment. This means that if the service providers are seeing slowing growth and a weaker macro-economic environment, they will cut back on expenditures for the foreseeable future. Cisco was adamant that it is seeing a broad weakness in Telco spending, largely as a result of Europe and macro-economic issues. Ciena cheered the market, but its stock performance has been more about a relief rally than any definitive evidence of a return to spending.

There is the issue for service providers of committing to a technological platform for its customers. More developed service providers are increasingly being faced with the choice of rolling out a new 4G/LTE network or expanding their existing 3G operations. Whereas in the emerging world while 3G spending remains active, some service providers face the choice of just jumping to 4G/LTE anyway. These sorts of considerations can delay decision making, because the service providers will have a tendency to wait until economic conditions are ripe in order to decide.

Capacity utilization has an obvious effect on spending plans. In terms of their own infrastructure, the carriers are faced with the decision to shift from 10G to 100G and possibly bypass 40G. In addition, when they see that top line growth is slowing there is a tendency to run existing capacity as long as possible before investing. Indeed, the messages have been mixed on this front.

Ciena talked of strength in the 100G market, of which they are particularly well placed, but the news from Finisar was not so positive. Similarly, whilst plenty of surveys and anecdotal evidence are highlighting the strains on load, the equipment manufacturers still haven’t seen a pick up in spending. Service providers seem determined to play ‘wait and see’. But, this can’t last forever.

Lastly, not all Telco spending is determined by corporations. While the key part of US spending is likely to be undertaken by companies like Verizon and AT&T, it is a different story in other parts of the world. Finisar mentioned that China's stimulus spending is hard to predict and I think this stands to reason.

A lot of optimism is being built into the market place in general over China’s ability to spend. However, investors need to consider that China remains a communist country and it is also ridden with corruption. Indeed, the central government is being very cautious over spending because it is not clear how much of it is misallocated or siphoned off by local governments and "fixers."

Whither AT&T and Verizon?

Taking a closer look at what these two companies said in their last outlooks is quite revealing. While companies like Finisar, Ciena and JDS Uniphase are making noise about a stronger second half, there doesn’t appear to be any sign of it yet in what the service providers are saying publicly. In addition, JDS Uniphase may be seeing things a bit better because it was more exposed to Thailand's flooding than Finisar, so its comparables will be easier to beat.

As for the carriers, AT&T guidance is for flat or "slightly more" capex spending this year. Turning to Verizon, here is what was said at the last results presentation:
“Capital expenditures totaled $3.6 billion in the quarter, a decrease of about $800 million compared to last year. Our overall capital efficiency continued to show steady improvement. We expect our annual CapEx-to-revenue ratio to decline for the full year based on improving revenue trends and disciplined capital spending.”
All of which, creates a rather confusing picture. On the one hand, they are being cautious over expenditures because of macro-economic fears, but on the other there are a veritable slew of new devices and applications that are ramping up demand for bandwidth.
Long-term demand for video and photo-rich applications is increasingly strong and, as noted earlier, the strains are starting to show. I happen to take the view that it is a question of when and not if there is a return to spending. These are secular demand trends and as smart phone penetration rates increase, the pressure on existing capacity is only going to build.

Time to Invest?

As ever, timing is critical in investing. It is very hard to pick a bottom in cycles. Anyone who tries should expect turbulence along the way. The key thing is that carrier spending has been sluggish for a while and there are the technological changes that are causing some delays in expenditure. However demand has been increasing and customer churn will only increase if carriers aren’t able to satisfy customer bandwidth requirements.

Given a resolution to the current macro worries over European sovereign debt, the sector could start to see a resumption of spending, but I think a cautious investor would wait until Verizon or AT&T starts confirming an increase in investment in their public statements. The biggest advantage that a private investor has is patience.

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