It seems I can't turn on the TV, pick up The Wall Street Journal, or visit an investing-related website without encountering a discussion of oil and oil stocks. After oil's big jump to more than $50 per barrel, many people are now wondering whether it's a good time to get involved. I don't know the answer, but I do know that, in general, the way to achieve better-than-average stock market returns is by looking in the dusty corners of the market to see what the hordes are missing. In investing, it definitely pays to be first to the party.
So where to look now?
I think The Wall Street Journal gave us a clue a few months ago, when it published a study ranking the stock performance of 76 industry groups from Jan. 1, 2000, to Jan. 1, 2005. In lowly 76th place were the telecom equipment makers, a group containing former highfliers such as Lucent
The five-year annualized performance of this group was negative-25.6%. JDS Uniphase was the worst of the bunch, with a head-spinning 47.7% average yearly drop. That means a $10,000 investment would have reverse-compounded its way to just $391. Well, guess what? It's been more of the same this year. JDS Uniphase closed 2004 at $3.17 per share and is now selling for $1.60; that remaining $391 is now down to $197.
The telecom equipment makers have been suffering because of the tremendous overcapacity that resulted from huge investments back in the bubble days. Ever since the bubble popped, these companies have been struggling to right their businesses in the face of plummeting revenues and gross margins. But most of these companies raised so much money during the bubble that too many of them have been able to avoid going out of business. That has stalled the prospects for a recovery in the industry. As a result, investors have left for dead many of the companies, notably those involved in fiber-optic communications.
It would be nice to know whether there's any reason to expect business to improve before investing in these companies. Well, I wouldn't have written this article if I couldn't find greener pastures on the horizon.
The skinny
Network capacity is not as large as widely believed. According to TeleGeography, an organization that tracks the communications industry, worldwide Internet traffic is growing by 115% per year. In addition, a recent column (subscription required to view) in The Wall Street Journal reported that the 10-year growth rate in Internet traffic is quoted as being 75% per year. Of course, there is no guarantee that the growth rate will remain at these levels, but I believe it's unlikely that the growth will suddenly crater far below the 10-year average.
In the United States, continued growth is likely -- even if at a slower rate -- because of greater consumer adoption of services like voice over IP, the transmission of phone calls over the Internet. But the faster growth is likely to occur in Asian countries.
The catch is that if the growth rate stays near the 10-year average, all of the currently available capacity on long-haul networks will be consumed within two years or so. You'd expect that telecom companies would start adding capacity a year or so ahead of that time to avoid bad service. And while the TeleGeography data tells us that network equipment spending should increase soon, there is evidence that the increase has already begun.
For example, in its annual survey of the laser marketplace early this year, optics-related trade publication Laser Focus World reported that growth in revenues for diode lasers used in fiber-optic communications was 21% in 2004. That growth occurred despite extensive competition in some segments of the diode laser market and resulted in steep price declines. While there is a danger that overcapacity will prevent laser manufacturers from being consistently profitable, the supply situation for one type of laser -- the pump laser, which is used to power optical amplifiers -- is in reasonably good shape.
If the Laser Focus World survey is correct, we should see proof of it in the revenue growth of companies that make lasers and other networking equipment. Well, after several tough years, revenues for many of these companies, including ADC Telecom and Ciena, did grow slightly in 2004. But even so, their stocks have fallen this year, and for most, the drops have been large.
Has the market overreacted, or are the drops justified because these companies may never be capable of making sustained profits, despite the revenue improvements? It's best to ask that of each individual company, since the upturn will probably not be so strong as to drive all of these businesses to strong profits. ADC Telecom recently announced much improved results for the most recent quarter, for example, but JDS Uniphase isn't doing as well.
What is driving the growth?One of the big growth drivers is fiber-to-the-premises (FTTP). If you send an email from a coffeehouse in San Francisco to a friend in New York, that email will be transmitted across the country through optical fibers. But the final mile or so to your friend's apartment is probably handled by an old-fashioned copper-wire network. This is somewhat analogous to flying across the country in a jet aircraft and then, after landing, hitching up a dog sled for the trip to your hotel.
Running optical fiber all the way to your front door will allow for delivery of the "triple play" of high-speed Internet, video, and phone service over the same fiber-optic cable.
Anyone who has a teenager monopolizing the telephone at home should be interested in at least part of the triple play. VoIP will allow you to talk to your parents in Peoria while your teenager talks endlessly to her friends, and you can do it without having to pay for an extra phone line. A second benefit is likely to be lower costs. The distinction between a long-distance call and a local call would probably go away; you could even eliminate your long-distance charges.
Verizon and SBC have both committed to large FTTP deployments by promising to extend fiber to millions of their customers. FTTP should be beneficial for equipment providers because a lot of electronics, optics, and connectors will be required to bring fiber to our doorsteps. This will have the ancillary benefit of increasing overall traffic on the long-haul routes (though at a moderated pace) that are responsible for carrying data over long distances. As a result, some of the unused fiber on these routes will have to be gradually put in service, or "lit up." To make unused fiber active, telecom providers will be forced to buy equipment for both ends of the fiber.
By increasing traffic on the long-haul routes, FTTP will drive additional investment there, as well as equipment to regenerate and amplify the signal periodically as it makes its trip.
But even though demand for networking equipment is likely to increase, it may not fill all of the network equipment makers' sails. Remember, there's a lot of capacity left over from the bubble. There are still too many companies making the lasers that transmit signals down the optical fiber, for example, so some of these companies are likely to go away unless the demand increase is huge. I would consider only the companies that seem to have a low valuation, are able to maintain reasonable gross margins, and are at least close to being profitable. It's also important to check cash flow statements to make sure your company does not have a voracious appetite for cash.
Some of these companies that got hurt when the bubble popped seem to finally be recovering. Investors, for the most part, haven't noticed. It's understandable that many investors would be cautious after taking the beating that the companies in this sector dished out, but it's the large declines in their share prices, coupled with improving business prospects, that may make for some good buys now.
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Fool contributor Dan Bloom would love to try dog sledding, but they don't make harnesses to fit the family Chihuahua. He is excited about the prospect of investing in the communications equipment industry, but he hopes that prices will remain low long enough for him to figure out which stocks to buy. He owns shares of ADC Telecom and 3Com. The Motley Fool has a disclosure policy.
