Lately we've seen a number of stocks in the telecommunications sector take quite a beating. I watched with concern as my shares of Nortel (NYSE: NT), Cisco (Nasdaq: CSCO), and JDS Uniphase (Nasdaq: JDSU) got hammered. What's going on? The short answer is that the extreme expectations of this industry aren't being met. It is costing a lot to build out networks, and the telecommunications companies aren't yet making the profits to pay for this. This leads to concerns that the suppliers will see declining sales, and may have trouble collecting on receivables.
One of the problems that have troubled the telecommunications companies is deregulation. This has opened up competition to many smaller, more-nimble companies. These companies weren't stuck with the legacy equipment of larger companies as was AT&T (NYSE: T), and can provide long-distance voice at a much cheaper price. For example, I was able to make calls home from Korea through a company that used Voice over IP (Internet protocol) technology last year for 10 cents a minute. You can carry a lot of information over fiber, so as the technology gets installed the cost of transmitting goes down. Carrying Voice over IP gets very cheap.
It's been known that the increased competition for the voice market would drive profits down, so to stay profitable the larger companies knew that they had to move over to data, broadband access for consumers, and wireless. Unfortunately, these aren't generating profits as rapidly as hoped, and the costs of installing the necessary equipment are very high. The auction of bandwidth has been costly, too; according to The Economist, the cost of 3G (third-generation wireless) licenses in Europe may approach $150 billion. These high costs can mean high debt.
Ultimately, the best comparison for what is happening to the telecommunications business is exactly what happened to the railroads in the 19th century. Originally, a large number of small railroads existed, and through the century a wave of consolidations occurred as some railroads grew bigger and others went bankrupt. The same problem occurred: How could you build a large enough network of rails fast enough to make a profit, but not go under from debt? (For an interesting take on this, check out Stephanie Cooke's article "Optical Train Wreck?" in Light Reading.)
For us as investors, what does this all mean? The telecommunication carrier stocks, such as AT&T, Sprint (Nasdaq: FON), and many others, are extremely risky investments right now. We don't know who will come out on top, and how the shakeup will work out. The Competitive Local Exchange Carriers (CLECs) are risky right now, and many of them are having financial problems. Even so, I have invested in those mentioned and in Enron (NYSE: ENE), which does provide a fiber optic network. However, Enron has some innovative ideas for bandwidth trading -- as does its competitor Williams Communications (NYSE: WCG) -- which may allow it to prosper while others are having serious problems. (See my earlier article on Enron, which is a popular stock among Fool Drip users.)
As for the equipment suppliers, the risk comes from two directions: competitive and "market." First, the industry is extremely competitive. The second risk is that of customers canceling orders, not paying receivables, and a slowdown in equipment orders. Due to the high competition, invest in industry leaders, not the ones pulling up in second place.
It is important to have a long time horizon for these stocks (at least five years). Also, we have to watch the industry and unload stocks in companies that are losing ground to competitors. This is not a "buy, hold, and forget" type of business, and there is not a "15-minute approach" to choosing telecom equipment manufacturer stocks. (Dollar cost averaging via Drips should help with volatility.)
Because the demand for bandwidth will continually increase as applications shove more data across the Internet, I believe that the telecommunications business is still a promising area for investment. For much more on telecommunications, visit the Fool's InDepth telecom and networking area.
