SUPERCOMM 2002: Time to Rethink the Capex Prognosis?

Cable Threat, OSS, Tech, Could Revive Spending Sooner Rather Than Later

Amid the unrelenting storm eroding capital spending in telecom, it may seem futile to look for a silver lining in the clouds overhanging this year's SUPERCOMM. A closer look at the market suggests spending across a wide array of equipment and software categories could become robust much sooner than many people anticipate.

Companies with deep pockets, namely the ILECs and a handful of others that are striving to make Wall Street happy by putting sharp constraints on capex, soon could find themselves increasing spending to keep those same investors happy. "There's a lot of talk about capex reductions, but the reality is that unless carriers cut their operating expenses they're not going to get the return on investments the market is looking for in the years ahead," says Al Safarikas, vice president of marketing for optical Ethernet at Nortel Networks.

Safarikas cites a recent joint report by McKinsey & Co. and Goldman Sachs that matches anticipated growth in demand for bandwidth and services against what the researchers anticipate will be "an extended downward sloping and volatile price curve." The upshot of the combined trends, the report says, is that ever more capacity utilization will not generate revenue sufficient to maintain necessary profit margins without a significant reduction in costs of operations, and that means network operators will have to spend money on technology in order to cut opex.

"According to our model, unless per-bit opex is reduced 25 to 30 percent per year through 2005, no reasonable amount of per-bit capex reduction will allow carriers to achieve a targeted ROIC (return on investment capital) of 12 percent in 2005," the report says. The researchers also note spending targeted to opex reductions isn't merely a spend-to-save proposition. "In addition to reducing costs, equipment and OSS providers can enhance profitability by helping [carriers] to deploy new, value-added IP services to expand the top line," the report says, noting that such services are likely to account for more than 30 percent of long-haul revenue by 2005 and that "very little of the infrastructure exists today to enable these services."

Cast in this light, the current use of capex reductions to improve the bottom line is likely to end fairly soon as carriers look to next-generation equipment and OSS for solutions that will cut operating expenses and produce new revenue in service categories not caught in the downward price trend. Even the most pessimistic observers and carrier executives tend to agree spending to cut opex is the next order of business. However, many scoff at the notion that any near-term uptick will affect overall spending.

The OSS Impact

Consulting firm RHK Inc., for example, over the past few months has become decidedly more pessimistic about the prospects for a turnaround. In November 2001, the consulting and research firm predicted North American wireline service provider capex would rebound in late 2002 or early 2003, going from $53 billion in 2002 to $80 billion by 2005. However its latest report, issued in April, says 2002 spending will be even lower, in the range of $46-$51 billion, and there will be no noticeable increase in capex until 2004.

"While traffic growth remains strong, average long-haul trunk capacity utilization is just 35 percent, and service providers have found numerous means to extract additional capacity from existing networks," says Melanie Swan, director of RHK's Telecom Economics Program. Given that IP traffic is forecast to grow 100 percent this year, she adds, the current level of capacity utilization "tells us service providers have little immediate need to spend much on new network infrastructure."

Still, RHK is also on record as predicting a sharp increase in OSS spending worldwide. In another report issued in April the company says global OSS spending in wireless as well as wireline will grow from $33.6 billion in 2002 to $49.6 billion by 2005. In particular, the company says spending on commercial software, systems integration, in-house development and element management systems will accelerate after 2002. "Despite reduced carrier spending in 2001, we expect investment in OSS to resume growth in late 2002," says RHK senior analyst Patrick Kelly. "Deregulation will begin to impact the market, creating new mega-carriers that will force competitors to reduce costs and time to market for new services. OSS will be essential as service providers strive to differentiate their services."

But, while Swan agrees there is an OSS spending imperative on the horizon, she doubts it will have sufficient impact to push overall capex out of the trough this year or next. In part, she adds, this is because carriers are not yet satisfied that they can get what they need from OSS solutions now on the market. "Most carriers are looking at what they can do there, but there are still a lot of questions about the solutions," she says. "It's not clear yet how OSS is going to lead into operations savings."

Williams Communications, for example, sees nothing on the horizon in the way of increased revenue that would justify a return to spending on network infrastructure. Given the ongoing drop in prices even as demand goes up, any spike from value-added service revenue is likely to be "just a drop in a large pond," says Williams senior vice president and general manager Bill Cornog. The priority at the service provider is on spending for systems and processes that will significantly reduce opex.

"That's a high priority for us," Cornog says. "Over the long term our ability to develop new processes around unique systems will be much more important to our ability to differentiate ourselves from the competition than the latest box from Corvis."

Cornog foresees continuing pain in the industry as consolidation and massive write-offs, not to mention more bankruptcies, bring rationalization to the industry's cost and debt structure. "People say forget about embedded costs and begin pricing on marginal costs, which leads to massive write-offs on balance sheets," Cornog says. "We think what we've done in writing down our assets isn't bad, because it allows us to begin healing. This whole thing is about being able to heal and compete." Williams, with its $2.9-billion assets write-down, already has taken a hit that many other carriers still face, he adds. The company filed for Chapter 11 bankruptcy protection in late April.

Revising Downward

Such thinking prompts Merrill Lynch & Co. to say that its own estimate of a 26 percent drop in capex for U.S. service providers in 2002 could be too optimistic. "Despite our forecast for a 26 percent decline in 2002, we believe the impact of continued bankruptcies, restructuring among smaller names, the voluntary drive to deliver FCF [free cash flow] at the major telcos and the 'involuntary' requirements to improve debt ratios will all exert downward pressure on our estimates," the company says in a report issued in mid February. (By "involuntary" the company means the indirect limits on capex created by ratings agency guidelines for specific rating levels and explicit covenant ratio requirements.) Indeed, with the latest round of quarterly earnings reports coming out at press time, several carriers announced they were revising their earlier 2002 capex estimates down. SBC Communications Inc., for example, says lower-than-expected demand will result in an unspecified decrease in capex from its previously announced target range of $9.2 billion to $9.7 billion. Similarly, Qwest Communications International Inc. cut its capex target for 2002, which had been set at $4.2-$4.3 billion, to a range of $4-$4.2 billion; WorldCom cut to $4.5 billion from the previous estimate of $5-$5.5 billion; Sprint Corp. revised capex downward from $6.8 billion to $6.1 billion; and BellSouth Corp. sliced $500 million from its earlier estimate to a predicted range of $4.8-$5 billion.

But against all these numbers and the overall trend among traditional telecom players, there is more than just the OSS imperative for opex relief working under the surface to put upward pressure on at least some areas of spending.

What makes these upward pressure points especially noteworthy is the fact that, as noted by Merrill Lynch, much of the capex constraint at the "major telcos" (meaning the RBOCs) is done "voluntarily" to meet FCF targets that are meant to keep investors happy. The question is whether that's a viable long-term strategy. It seems that service providers' need to make hardware and OSS investments to effect opex reductions and meet competitive challenges, especially from the cable industry, could force the telcos to rethink their capex caps sooner than later.

Indeed. Even as the RBOCs posted their latest retrenchments in 2002 capex, vendors were reporting intensified activity on RFPs that had been in a more or less dormant state for the previous year or so.

Totally apart from the demand slump brought on by the economic downturn, the current spending slowdown is a natural consequence of a major shift in strategic thinking about spending priorities, notes Rob Redford, vice president of marketing for the Internet Routing Group at Cisco Systems Inc. "It's not that they don't have money to spend, it's that they have to think in new terms about their spending priorities," Redford says. "Where, traditionally, 50 to 75 percent of capex has gone into preserving the existing infrastructure without generating new revenue, now they have to figure out how to allocate resources that will result in lower capital and operating costs while generating new revenue in the future. That's a tough thing to do."

Continued regulatory uncertainty adds to these difficulties, Redford says. If, as seems likely, RBOCs get the go-ahead to offer long distance in most of their markets this year and gain clarity and relief with respect to rules governing network unbundling and open access, they'll be in a much better position to take action on next-generation hardware and software that meet the opex and new revenue requirements, he says.

Tech-Driven Spending

Redford points to the capabilities surrounding implementation of MPLS technology as one of the major factors in carrier preparations for new spending, which is a point that was made repeatedly by other vendor representatives in interviews for this issue's story on MPLS (see page 28). By allowing carriers to continue delivering existing TDM-based services while adding packet-based VPNs and Ethernet LAN services over existing infrastructure, MPLS-equipped products represent a low capital cost approach to generating new revenue and to achieving operations efficiencies at the network edges, Redford says. And the technology provides a means by which services can be integrated over long-haul networks as the RBOCs move into that business.

Moreover, ILECs and others are looking at wholesale transport opportunities associated with increasing demand for content distribution across IP backbones on the part of software, programming network and web portal companies. "IP VPNs enabled by MPLS become a virtual backbone for content providers," Redford says.

Just such opportunities are a big reason Level 3 Communications Inc. is launching MPLS-based private line Ethernet, ATM and frame relay support across its networks in the United States and Europe, says Eric Zines, product manager for the new services. "This is a different set of market demands," he says. "We're not just shifting revenue around."

One of the big attractions of MPLS and other innovations entering the marketplace, such as edge gear that readily compacts Ethernet into SONET, is the relatively low costs involved for potentially big paybacks. Technology has reached the point where the legacy infrastructures carriers have spent so much on during the past five years can be parlayed into next-generation platforms that produce major operations savings while generating important new revenue streams at low levels of incremental spending.

"The way we approach MPLS is it's code on a router," says Mike McAndrews, director of IP services at Williams.

Similarly, XO Communications is launching a new Layer 2 unprotected Ethernet 100mbps and 1gbps service using existing ring infrastructures at low costs, which are incurred only with the signing of a customer, notes Garrett Hess, senior product manager for Ethernet services at XO. "We're able to deliver a higher speed service with four 9s reliability at a 30 to 50 percent discount to private line services offered over ATM and frame relay." Demand for private line services, reflected in the growth of customers who have multiple locations they want to reach with the connections, has been remarkably strong, Hess adds. He notes this gives a company with a national footprint an advantage over ones like the ILECs that are bound to a single region. "At the start of 2001, we were registering five multiple-location sales per month; by the end of the year the number was 70 to 75 per month," he says. "We're definitely seeing a trend toward medium and larger enterprises seeking a single solution for multiple locations from a single provider of multiple services."

Meanwhile, the market picture created by traditional telecom spending analysis of the new realities of broadband competition is distorted when the cable industry isn't taken into account. For example, none of the telecom capex studies reviewed for this article included cable. Cable traditionally has been viewed as an entertainment medium with capex relative to cable-specific suppliers. Today cable is becoming a major source of demand for gear that also is used widely in telecom, notes Cisco's Redford.

"We haven't seen any dampening of their strategies to use data infrastructure," Redford says of the cable companies. "They see the benefits of building IP backbone infrastructures that allow them to tie together all their transport over their metro networks. Everybody is talking about transporting video on demand over the data network. And use of data networks to deliver commercial services to businesses is complementary to what they're doing, since 75 to 80 percent of the businesses in any given market are passed by their fiber networks."

Cable also is becoming a serious player in voice, which taps the traditional circuit-based infrastructure supply line as well as the data product base. And, as cable moves into voice and commercial services and continues its expansion of high-speed data in the consumer market, the competitive pressures on the ILECs multiply. "I'd certainly expect competitive pressures to force more investments into solutions that generate more revenue over existing infrastructure," Redford says.

Potential Hot Spending Categories

OSS

RHK forecasts OSS spending worldwide will grow from $33.6 billion in 2002 to $49.6 billion by 2005, representing a cumulative annual growth rate of 14 percent. Commercial suppliers will capture 40 percent of all OSS expenditures in 2002, which is a departure from spending in the '90s, when internal spending accounted for about 90 percent of the overall budget. In North America the independent software vendors' share of OSS budgets is even higher, hitting 49 percent last year compared to 26 percent in Europe.

Glut or Capacity Exhaust?

In a widely cited research report, TeleChoice last year conducted a study of 22 major U.S. city-pair routes with respect to the ratio of traffic loads in 28 different user application categories to the available lit fiber capacity on those routes. On virtually all routes the company found a good balance of supply and demand, which is to say, no glut. Typically, when utilization reaches more than 70 percent of capacity preparations are made to light new fiber. TeleChoice found, however, that many routes were above 70 percent without new fiber having been lit, which indicates pent-up demand for new equipment resulting from the slowdown in capital spending. Based on this and other studies, TeleChoice says that "bandwidth glut is indeed a myth. Demand for bandwidth is growing and could outstrip current lit supply very soon." The summary of TeleChoice's findings is as follows:

• 14 of 22 routes greater than 70 percent ratio of demand to supply

• 17 of 22 routes greater than 60 percent

•   4 of 22 routes less than 50 percent

Edge Routers

Synergy Research reports the market for service provider edge routers surged by 21.5 percent in the fourth quarter 2001 over Q3. "Over the past four quarters service provider edge routers and enterprise high end had been flat or decreasing in importance in the router market," says Susana Vidal, industry analyst with Synergy. "This quarter the trend changed, showing signs of a shift in expending priorities in the carriers and large enterprises." During the same quarter, she notes, overall router sales decreased by 9.5 percent. Such findings square with the experience of Unisphere Networks Inc., which is credited with holding 15.6 percent of the service provider edge market share. "The demand is there; we've been responding to a lot of RFPs," says Mike Sheehan, product manager for Unisphere's IP routing division. "Wall Street scares everybody, but you will see fast growth at the edge to accommodate connectivity to the optical core."

Optical Metro

Cahners In-Stat/MDR says its research shows spending on metro optical network gear, including traditional and next-generation SONET, DWDM and optical Ethernet, will grow from $13 billion in 2001 to $23.6 billion in 2005. Spending in this category will be "minimized" through the first half of 2002 but will begin to pick up later in the year and beyond, says Norm Bogen, a director at In-Stat.

Metro Access

Expenditures for metro access products and services by enterprise end users will grow 552 percent from $420 million this year to $2.7 billion by 2006, says Infonetics Research. Eighteen percent of respondents said that by 2004 all their sites will be connected using only new metro access, including Ethernet, SONET, passive optical networking gear and DWDM. Ethernet will be the dominant new metro access connection, the study says.

Residential Broadband

One measure of service provider spending on broadband services in the consumer market is the pace at which they will move from merely supplying high-speed modems with their DSL or cable data services to supplying gateways supporting advanced service packages, including data, voice, home control and entertainment that are distributed from the gateway interface with the external network over the home network. Cahners In-Stat/MDR's latest research on the subject, issued in March, shows the market for such gateways will increase from $125 million in 2001 to more than $5 billion in 2006. "The increased use of broadband, combined with the development of new and interesting ways to interconnect devices in the home, has put the residential gateway on the map of nearly every vendor in the modem, router, set-top box, CPE silicon and consumer software space," say Mike Wolfe, a director at In-Stat. "We believe that over time the service providers will overcome the current capital expenditure constraints inhibiting this market and move to a predominantly residential gateway-based customer termination strategy."

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