CAPITAL SQUEEZE

Last week brought more weak earnings and massive layoffs for major service providers, prompting SBC Communications, AT&T and WorldCom to cut 2002 capital expenditures by 20%. Equipment vendors must alter their strategies to ensure they get as much of the available pot as possible.

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This week, Verizon Communications will announce capex reductions for next year when it issues its third quarter 2001 results, according to sources close to the company. Previously, Sprint and Qwest Communications announced sizeable reductions in next year's capex (see figure below).

If Chairman and CEO Duane Ackerman's stance is any indication, BellSouth will soon follow suit. According to sources, Ackerman told an analyst conference last month that capex would “trend lower” in 2002 compared with this year, which is running about 10% lower than 2000 spending levels. (BellSouth is set to announce its 2002 guidance Nov. 5.)

FALLING CAPEX BUDGETS  FROM MAJOR CARRIERS (in billions)
COMPANY	Original 2001 capex	Current 2001 capex	Projected 2002 capex
AT&T*	$4.38	$4.38	$3.51
Sprint (FON Group)	$6.2	$5.4	$4 (INITIAL ESTIMATE)
WorldCom	$7.5 to $8	$7.5 to $8	$6
Qwest	$9.5	$8.5	$5.5
SBC	$12.5	$12	$9.6
BellSouth	$5.5 to $6	$5.5 to $6	Guidance expected 11/05
Verizon	$18.5	$17.5	Guidance expected 10/30
*Business and consumer units only. Projected figures based on expenditures for the first three quarters of 2001 Source: Companies

There are a number of hypotheses for the cuts. One theory holds that with the effective demise of competitive carriers, Bell companies are no longer being pushed to invest in new technologies. “The CLECs are clearly distressed, so the RBOCs no longer see the need to upgrade their networks in the near term,” said Michael Balhoff, managing director of Legg Mason and head of its telecom group.

Carriers also might be cutting back on spending because they can take advantage of distressed equipment vendors, Balhoff said.

Qwest Chairman and CEO Joseph Nacchio has pointed out several times that vendors can be squeezed.

Kurt Fawkes, vice president of investor relations for Sprint, acknowledged that the company is seeing better prices from vendors. “They're hungrier today than they were 12 months ago.”

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Another more clandestine theory claims carriers are holding off on investing in their networks to pressure regulators for relief on the issue of total element long-run incremental cost, TELRIC (see related story). “The government needs to stop taking away the incentive to invest,” said Scott Cleland, CEO of The Precursor Group.

Still another theory says former Bell companies anticipate an eventual consolidation with interexchange carriers and consequently are holding off making significant investments in products and technologies they may not want or need in the future. “The strategy guys are trying to figure out who they're going to merge with and are taking that into account as they develop their long-term infrastructure plans,” said Patrick Comack, senior analyst for Guzman & Co.

Most likely, however, is that carriers are simply feeling the widespread economic pinch. SBC Chairman and CEO Ed Whitacre called the current conditions the “toughest economic climate we've seen in many years,” adding that the carrier would need to “make some tough choices.”

What Whitacre said isn't unique—five of the seven major carriers already are stating explicitly that they're throttling back—but the end result will end up burning vendors, said Ron Westfall, analyst for Current Analysis.

At first glance, one wonders just how tough those conditions are when a company turns a quarterly profit of $2 billion, as SBC did in the just concluded third quarter.

But Nikos Theodopolous, analyst for UBS Warburg, said Wall Street uses a different scale when measuring a company's performance, giving greater weight to revenue and earnings growth.

In general, service providers have fallen flat on both over the past several quarters. “There's a big push for operators to show better cash flow,” he said. “This is forcing them to place a bigger emphasis on spending more frugally.”

Maribel Dolinov, senior telecom analyst for Forrester Research, believes carriers won't increase their spending until they have at least a couple of solid quarters under their belts. “They're going to have to demonstrate to the investor community that they can get a return on the stuff they've already put in,” she said.

The push for Section 271 relief also is forcing the former Bells to divert capex monies into their legal and lobbying budgets.

But the economy may make that difficult, according to Vik Grover, senior analyst for Kaufman Bros. “Every time someone is laid off, there's one less line,” he said.

Overall carriers' capex this year was about 30% of revenues, according to Comack. He predicted it would be 25% next year but cautioned, “In a recession, it can go as low as the high teens.”

Taking the blunt end of the stick are equipment vendors, which must quickly develop revenue-saving products or take market share away from their competition. “The vendors are walking through the valley of the shadow of death right now,” Dolinov said.

According to Bill Nuti, senior vice president of worldwide service provider operations for Cisco Systems, carriers are most interested in higher-margin services, and that means data services — managed IP telephony, e-learning and storage management — that are based on packet-switch technologies.

“They need to drive year-over-year growth, and voice isn't doing it,” he said. “Vendors need to develop products based on where the market is going and do a better job of listening to their customers.”

They also have to start getting realistic, Dolinov said, who suggested vendors had begun taking for granted the multibillion dollar orders they had been receiving. “Right now, a $10 million order is a good thing,” she said.

However, a recent UBS Warburg survey of 30 telecom service providers suggests that capex spending for 2002 will reach $80 billion. “These are still big numbers,” Guzman's Comack said.
With additional reporting by Donny Jackson and Toby Weber in Chicago and Lynnette Luna in Denver.