In Telecom, What's Good for the Goose Could Kill the Gander


It's hard out there for companies selling telecom equipment gear. To see why, you need look no further than the latest earnings news out of Verizon (NYS: VZ) .

Verizon released Q3 earnings last week. The headlines were all about 4% revenue growth and 14% growth in earnings. But if you dig a little deeper, I think you'll also find Verizon's news contains one really disturbing trend for telco equipment makers such as Alcatel-Lucent (NYS: ALU) , Ciena (NAS: CIEN) , and Infinera (NAS: INFN) . Namely: the fact that so far this year, Verizon has seen a monster leap in free cash flow, up 50% year to date.

That's terrific news for Verizon and its shareholders, of course. It means that over the past 12 months, Verizon generated $18 billion in real cash profits. Considering that at last report, archrival AT&T (NYS: T) -- a company with a 60% bigger market cap -- has only managed to churn out $15.7 billion in an equivalent time span, or 13% less -- it's quite an accomplishment.

Good news for the goose...
The reason for this huge boost in cash production is, of course, Verizon's major slowdown in infrastructure build-out. (A trend we've noted multiple times in recent weeks, by the way). So far this year, Verizon has invested about $11.3 billion in capital spending. That's 10% less than what the company spent through the end of its fiscal third quarter last year, and about 30% less than the company spent in all of last year (and with less than 25% of the year remaining).

Granted, on the plus side, capital expenditure was up about 7% year over year in Q3 specifically. Capital spending on wireless equipment rose an even more encouraging 20% (albeit it's still down 16% year to date). This has some investors imagining they now see the kind of "green shoots" that could foreshadow a rich harvest for Alcatel, Ciena, and their peers if the sales revival in wireless equipment gains strength. bad news for some ganders...
But here's the thing: These companies don't just sell wireless equipment. They also sell wireline, and at Verizon, capex spending on this latter category of equipment began trailing off even as Verizon upped its spending on wireless a bit in Q3. After trending toward a 3% drop in capital spending for the year, wireline equipment investments dropped 8% in Q3. So essentially, wireline spending cuts are canceling out part of the growth that we began seeing in wire-less equipment buying in Q3.

Further complicating matters, Verizon may turn out to be a better customer to the telco equipment makers than its peers. The Wall Street Journal recently prognosticated, for example, that AT&T will soon be "the largest spectrum owner among major U.S. wireless companies ... by a large margin." With plenty of spectrum under its belt, and a big discrepancy in its free cash production relative to rival Verizon, AT&T may have incentive to spend less on capex rather than more going forward, as a means of boosting cash production.

...and potentially even fatal
Granted, investment in infrastructure -- telecom infrastructure included -- is always cyclical. If you're a big telco like Verizon or AT&T, standard operating procedure is to overinvest until you realize that's what you've done, at which point you cut back, sit back on your laurels, and coast on your accomplishments... until traffic picks up and you realize you're underinvested. At which point, the investment phase starts all over again.

Problem is, if you're a supplier to a telco, you have to stay solvent during the down periods so that when the boom returns, you can get rich off of selling your wares to the telcos. This could be a problem for companies like Infinera, which isn't currently profitable (as GAAP accounts for such things) and is burning cash, to boot. It could be even more of a problem for Alcatel, which, while technically "profitable," hasn't had an actual free-cash-flow-positive year since it merged with Lucent way back in 2006 -- and is starting to run out of cash.

My guess: Your best bet to capitalize on a revival of telecom spending (if it's truly begun), or to stay in the game until the revival arrives (if it hasn't) is Ciena. The company generated $94 million in cash profits over the past year, even as its GAAP records showed a loss. At a price-to-free-cash-flow ratio of just a hair over 13, and long-term growth estimates hovering around 17.5%, Ciena's simply the safest play in the space, and the best bargain of the bunch.

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Fool contributor Rich Smith has no positions in the stocks mentioned above. The Motley Fool owns shares of Infinera. Motley Fool newsletter services recommend Infinera and AT&T. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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