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Last year was difficult for companies exposed to telco spending, but will 2014 bring better conditions? There are countless questions regarding this issue, but for the sake of brevity, this article will focus on demand trends coming from Tier 1 service providers like AT&T (NYSE: T ) and Verizon (NYSE: VZ ) and touch on prospects from emerging markets. The type of solutions being bought by AT&T and Verizon will dictate selling opportunities for companies like Cisco (NASDAQ: CSCO ) and Ciena (NYSE: CIEN ) as well as many others in the telco space.
AT&T and Verizon
The issue facing service providers in the developed world is that average revenue per user is falling because technological advancements have reduced the importance of fixed and mobile voice usage. As a consequence, carriers like AT&T and Verizon are trying to reduce capital expenditures as a share of revenue, even while revenue growth is slowing. Verizon's capital expenditure of $16.1 billion in 2012 is approximately $930 million less than it spent in 2006. Conversely, AT&T's have been rising, but this is largely due to the roll out of its 4G/LTE network later than Verizon.
In addition, both companies have given lackluster capital spending forecasts. AT&T's management stated, "we would expect the CapEx for this year to be in $21 billion range and for '14 and '15 to be in the $20 billion range."These figures are below what AT&T has spent in previous years. Meanwhile, Verizon argued that "As far as CapEx goes, I have been pretty consistent here. You should consider us improving our CapEx-to-revenue ratio going forward."
Smartphone penetration driving growth
However, the reality is that service providers will still have to invest, just in different ways. The trend carrying over from 2013 is that Verizon and AT&T have been surprised by the strength in the increase of smartphone penetration, while seeing disappointments at the lower end. On AT&T's recent conference call, management outlined:
We now have 75% of our postpaid phone base on smartphones. We expect that percentage to keep growing. These are the premium subscribers in our business. They have twice the ARPU of non-smartphone subscribers and much lower churn.
Meanwhile, the company saw "some pressure" with its "subscribers on low-end 2G feature phones." Verizon told a similar tale of increasing smartphone penetration to 67%. Verizon is also seeing strong growth in 4G take-up, with 38% of its retail postpaid customers on 4G, versus 33% in the previous quarter and only 17% last year.
These trends are likely to make carriers in the developed world focus on purchasing higher-end networking solutions, rather than investing in maintaining older networks. This might hurt a company like Cisco, but it will benefit Ciena with its next-generation technology. Ciena is particularly strong in 40G and 100G ethernet networking and optical transport networks. As for Cisco, service providers make up around 31% of its revenue. They matter a lot to the company, but Cisco is only expecting 0%-1% growth in switching and routing over the next 3-5 years.
Emerging market opportunities for Cisco and Ciena
The great imponderable for 2014 will be emerging market telco spending. Cisco's outlook for emerging markets was extremely weak, and if taken at face value, it's hard not to be cautious. On the other hand, if emerging markets follow developed market trends, expect smart phone penetration and data usage to increase strongly in 2014.
Moreover, many emerging market countries have the opportunity to jump to next-generation technologies like 4G/LTE, rather than invest in 3G or maintaining legacy infrastructure. Again, this might play to the strengths of Ciena rather than Cisco. However, Cisco has set the bar so low with regard its emerging market prospects that any upside surprise is likely to be well-received.
The bottom line
It's hard to get too excited by overall North American spending because AT&T and Verizon have made it clear that they are not planning a major ramp up in spending. However, the type of spending taking place means there will be winners and losers in the process. As for emerging markets, much will depend on the macro-economic climate. However, with most forecasters predicting stronger economic growth this year, it's reasonable to expect a better year overall. But, the investment focus should still be on niche players like Ciena, rather than larger all-purpose telco suppliers.
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