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Telecom’s Big Bet: How Much Will the Carriers Spend?

The tech sector will supply the plumbing for our high-bandwidth future. Question is, when will the carriers resume orderin

If you’re the daring type who likes a highly speculative bet in tech, you’ll find no greater drama than the telecom equipment market, where the vast projects of building the pipes of the Internet is an adventure of promise and peril.

Companies such as Ciena (ticker: CIEN), Alcatel-Lucent (ALU), and Nokia (NOK) had a lousy 2014. A survey of 25 equipment companies listed on the Nasdaq and NYSE shows an average price change of negative 5% in the last 12 months.

What’s hampered returns for all of these vendors is that spending by telcos such as AT&T (T) and Verizon Communications (VZ), ostensibly pots of gold within easy reach, proved to be precarious in 2014 as quarter after quarter tens of billions of dollars in spending turned out to be “lumpy”—Wall Street jargon for when purchases don’t show up as quickly as expected.

JDS Uniphase (JDSU), which makes lasers that go into communications equipment sold by Ciena and others, laid the “softness” in the telecom market at the feet of “M&A distractions,” a nod to gigantic deals, like Comcast (CMCSA) trying to acquire Time Warner Cable (TWC) and AT&T in the process of buying DirecTV (DTV).

Cisco Systems (CSCO) chief John Chambers told the Street in November that the culprit was policy debates in Washington over how much carriers can charge Netflix (NFLX) and others to carry bits across the Internet. “Two to three U.S. service providers have dramatically slowed their order rates, and I mean dramatically slowed order rates with us,” Chambers said in November.

ALL OF WHICH MADE FOR A DRAMATIC 2014. But that pot of gold still tantalizes. Carriers spend an awesome amount of money: AT&T probably shelled out $21 billion last year, Verizon, perhaps $17 billion. Not to be beat, China Mobile (CHL), the world’s largest operator by subscriber count, at 790 million customers as of June, is in the midst of building out China’s faster 4G wireless network.

In June, China Mobile said it had already spent $13.5 billion on capital investments for the first half of the year.

On every continent, the spending is driven by the need to put up more cell towers and base stations closer to each smartphone user, and the need to increase Internet bandwidth to homes and offices for the transmission of more and more video content from Netflix.

Some of the beat-up names trading at the cheaper end of the spectrum are worth a look: They’re excellent companies, with businesses that are not going away, though it’s just a little difficult to predict what will occur in any given year. Ciena, trading at 16.5 times forward earnings with its shares down 16% in the last 12 months, is an excellent name. Another is Harris (HRS), a maker of radio systems installed in cell towers. Harris trades at 13.5 times forward estimates, its shares down 3%.

Although its results have been somewhat erratic, Arris Group (ARRS) is an interesting way to gamble on the expansion of the cable plant, or wiring and infrastructure, and its shares trade at a bargain-basement 9.8 times forward earnings. Arris was up 6% in the last 12 months.

Ruckus Wireless (RKUS), the maker of Wi-Fi networking equipment for use in dense urban environments, trades at 15.4 times forward estimates, yet it may generate a respectable 21% revenue growth this year after 25% in 2014, analysts estimate. Ruckus shares fell 37% in the last 12 months. A shooting star of an initial public offering in late 2012, it rose 60%, then crashed to earth.

Alcatel, and two other traditional equipment makers, Ericsson (ERIC) and Nokia, are also worth a look. Alcatel’s American depositary receipts fell 26% in the last 12 months. Along with Nokia, it’s a restructuring story. Nokia shares fell 5%. Ericsson stock was flat in that time. At 14.9 times forward earnings, Ericsson’s stock is not overly demanding.

Starting this week, investors will get updates on what the carriers intend to spend. Verizon reports results Jan. 22, AT&T Jan. 27, and Sprint (S) Feb. 5. T-Mobile US ’s (TMUS) date is not yet set.

It’s already known the carriers won’t increase spending dramatically. AT&T has said it will trim outlays to $18 billion in 2015 from last year’s $21 billion because network improvements have been completed faster than expected.

Weighing on the ability to spend on equipment are the staggering amounts the telecoms must still lay out for their other big priority: wireless airwaves.

Craig Moffett, proprietor of the boutique MoffettNathanson research firm, estimates that AT&T and Verizon may each spend as much as $18 billion on one government auction that is currently drawing to a close. Another auction in 2016 may draw bids from T-Mobile and Sprint as well.

Spectrum acquisition eventually leads to further equipment purchases, but only after the carriers figure out how to pay for their bids. Moffett thinks AT&T may need to issue another $14.5 billion of bonds this year to fund this latest round of spectrum purchases. That’s on top of an existing $71 billion in long-term debt for AT&T.

Faced with the precarious nature of spending, Ciena is emphasizing the ways in which its business is changing, as the company explained to me during a recent visit to its headquarters. Chief Financial Officer James Moylan pointed out that Ciena is getting more and more business from companies other than the phone companies. “AT&T and Verizon combined were once approximately 40% of our revenues,” he observes. “Today that’s down to maybe 25%.”

WHAT’S REPLACING THE PAIR are Webscale companies— Google (GOOGL), Amazon.com (AMZN), and other stars of cloud computing. Today, Google and others make up 10% of sales of transport equipment, the fastest fiber-optic pipes Ciena sells. That may rise to 15% in two to three years.

CEO Gary Smith argues that Ciena can in coming years lift its operating profit margins beyond the 8% to 9% target it has forecast this year by selling more software capabilities. “If you go back to the period before the recession, Ciena had operating margins in the midteens, consistently,” he tells me. “Even if you don’t believe in some brave new world for telecom equipment, the way things were not so long ago proves we could achieve those margins, and a lot of that was through our software.”

Companies such as Ciena, Nokia, and Ericsson have a good business that’s worth investing in, as long as you’re willing to stomach the uncertainty along the way.