Follow the Money
Telecom Calls
This may be the digital age, but the data dispatched through your modem still travels over analog telephone lines. That will soon change. Who is likely to supply the digital lines? The telcos. And who will supply the telephone company with the equipment to build those lines? Some very interesting investment opportunities.
After years of slow change and steady, modest growth, the telecommunications equipment market is booming, driven by a combination of deregulation, new technologies, and strong international demand.
Worldwide telecommunications spending is divided between equipment and services. For every dollar spent on equipment - an estimated US$180 billion in 1997 - telcos spend another $5 on local and long distance calls, directory assistance, and other services. Worldwide services spending should grow 10 percent a year for the next few years, driven by falling prices in developed countries and first-time availability in developing nations. Overall equipment sales will expand at twice that rate as competitors, scrapping for market share, race to offer new and improved services.
Sales in the developing world are growing fast. But thanks to deregulation and technical improvements, the developed markets - which account for only 14 percent of the world's population - still consume 85 percent of equipment sales.
A telecom primer
The US telephone network has three major components: the local-access network, the public switched phone network (PSTN) backbone, and the Advanced Intelligent Network.
The local-access system, or local loop, carries voice and data traffic from the subscriber to the central office, which routes local calls and connects nonlocal long distance traffic to the PSTN for transmission to other central offices.
For nearly a century , the standard connection to the central office has been a pair of twisted copper wires carrying a 64-Kbps analog signal. This narrowband or voiceband subscriber line is connected to a line card in the local exchange switch at the central office.
Historically, the ratio of line cards to PSTN connections has been about 4-to-1, because statistics showed that a typical person makes about five nonlocal 10-minute calls a day. When a call is placed, the local switch creates a circuit, dedicating one of the PSTN connections to the call. If 25 percent of the subscribers are on the line, everyone else gets a busy signal.
More recently, the industry has developed alternate routes to the central office to circumvent the analog line card and digitally switch into the PSTN. Pairgain technologies, which convert analog traffic to digital, can carry 32 conversations. This increases capacity without the expense of increasing the number of wires.
The business PBX (private branch exchange) usually connects to the central office via a digital T1 line at 1.54 Mbps. Other technologies that extend digital transmission into the local network include ISDN for 128 Kbps service over two dedicated channels connected to the local exchange switch, ADSL for higher speeds up to 8.4 Mbps, and DLC - digital loop carriers - connecting 96 or more narrowband lines onto a high-speed trunk (consisting of four T1s) and then to the central office. These technologies serve different tiers of service at different price points, and all will be part of the evolving telecom landscape.
But back to investing ...
In the equipment sector, the big seven providers include Lucent (formerly AT&T), Northern Telecom, Alcatel, Siemens, Ericsson, Fujitsu, and NEC. These vendors make or acquire the access, switching, and transmission technologies necessary to build a network from end to end. Big, diversified, and well followed, these companies tend to be fairly valued, so I'm not buying any of them right now. Good values do arise from time to time. Look for a chance to buy companies at less than eight times growth flow (earnings per share plus R&D per share) with sales growing at least 15 percent each year.
Small companies are driving the market in access devices, which concentrate traffic from different sources onto digital trunks connected to the central office. Many access devices connect one of the broadband data-transmission standards like asynchronous transfer mode or frame relay to the switched telephone network. In this area I like Sync Research (SYNX); its stock is down from $20 last November to less than $4 because of a flat fourth quarter, which overwhelmed the good news of an important network contract from Visa International.
More sophisticated devices offer integrated access for multiple forms of data and voice traffic transmitted over digital trunks to the central office. The leading company is Premisys Communications (PRMS), whose stock tumbled from $65 to less than $8 when its major reseller, Paradyne, lost a couple of contract bids. Premisys competes with Newbridge Networks, Tellabs, and Nokia, but offers the most flexible and powerful integrated access solution. Buy both SYNX and PRMS up to $12.
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The portfolio is underweighted in communications stocks, which had been overvalued for months before coming down hard in the first quarter. I am adding 17,000 shares of Premisys. The new advanced object relational database made by Informix (IFMX) can handle any type of data, including multimedia information, and gives the company a substantial technology lead. I am buying 3,000 shares.
Michael Murphy is a money manager who publishes the California Technology Stock Letter in Half Moon Bay, California.
