Generation gap hits equipment side

Equipment vendors may find this to be a watershed year for proving out their next-generation strategies, separating winners from losers in the contest to migrate carriers from legacy gear. Vendors' success at this crucial juncture will be determined largely by how they manage the revenue gap between declining sales of legacy gear and the growth of next-gen replacements.

Last fall, CEO Pat Russo said Lucent Technologies' next-gen equipment revenue growth would not outpace its legacy revenue decline until 2007. In 2006, she said, that decline would only be “largely offset” by next-gen growth. Based in part on that premise, Lucent later predicted flat revenue for 2006. But when first-quarter results came in last month, Lucent's outlook dimmed, and it predicted revenue to decline this year.

“The ramp-up in spending is occurring more slowly than we anticipated,” Lucent's Chief Financial Officer John Kritzmacher said in April. Lucent's predicament is somewhat lost amid its mergers with Riverstone Networks and Alcatel, but other vendors face the same hurdles.

UBS Investment predicts U.S. telcos to spend 10% to 15% of their revenue this year, with spending on next-gen wireline gear near the 15% mark, and spending on legacy gear at 10% or below. Carriers are hoping to staunch wireline service revenue loss with investments in new access and optical infrastructure, as their enterprise customers are increasingly opening up to next-gen technology. The domestic market for frame relay services, for example, peaked last year at $9.8 billion, according to Vertical Systems Group, which expects the market to be $9.7 billion this year. Meanwhile, the market for Ethernet and IP VPN services, though only about $6 billion combined, is growing about 30% annually.

“Multiservice ATM gear still sells pretty well,” said Glen Hunt, Current Analysis senior analyst. “We thought that stuff would be gone a number of quarters ago. We're starting to see it trail off now.”

Tellabs reported surprisingly strong sales of its legacy cross-connects to wireless carriers in the first quarter (Cingular in particular), despite analysts' expectation that the business is due to peak. Those legacy dollars give Tellabs more runway room to grow its next-gen business, which is already gaining speed. Tellabs won a coveted Verizon Communications contract for reconfigurable add/drop multiplexers last year and met its goal to sell $60 million worth of its new 8800 edge routers last year despite the loss of a major customer, C&W.

Sales of the 8800 fell sequentially in the first quarter to $15 million (still puny compared to more than $200 million from the old cross-connects), but analysts see a healthy pipeline for the product and expect it to grow. All eyes will be watching to see if Tellabs holds its position in the access market as the Bells migrate to Gigabit passive optical networks, but analysts are optimistic about that, too.

In contrast, access vendor Zhone Technologies' first-quarter revenue fell short of expectations because of a more than 20% sequential drop in its legacy equipment business (which contributes about a third of its total revenue). In the face of that gap, however, analysts say Zhone's problem is not low legacy sales.

“What's been more disappointing is the traction on new products,” said Joanna Makris, Canaccord Adams analyst. “We'd like to see the new products garner more enthusiasm. That will take time.”