An e-mail a few months ago from a gentleman who worked for a phone company warned about the attrition of older product platforms and the employees that have supported them at the major equipment providers. He said that was going to jeopardize carrier networks and force new equipment spending. He was encouraging us to write about the subject. Our initial reaction was that he must be a dislodged former employee trying to whip up some hysteria in the hope of inspiring greater vitality in carrier hiring. We now believe his encouragement may have been entirely genuine and his warning legitimate.
We recently spoke to a carrier whose job is to evaluate new hardware for his employer's network. For the two years leading into 2002, his employer has cut headcount. Industry conditions this year have precipitated more cuts, and the rumors within his shop are that more are coming before long. At the same time, this carrier has not put a new platform in the network for the past three years. A number of his installed vendors are making decisions to discontinue support for gear that is currently supporting the carrier's services. Instead of evaluating new hardware, this employee is putting together strategies to support these soon-to-be-deserted platforms.
Traffic is growing, albeit at a slower pace; carrier headcount is down and getting lower; installed vendors are being forced to walk away from legacy equipment support—and no one thinks we'll be needing new technology gear anytime soon??? That sounds like a problem facing many carriers today—the solution is next-generation platforms and higher capital spending. Without better revenue and cash flow performance, increased capital spending is unacceptable to investors. Something has to give, and maybe it's the stupid pricing practices of carriers looking to take the other guy's business for a penny less a minute. Higher prices or at least price stability has to become a topic soon. It may be a bit difficult for an industry being accused of criminal activity to think of higher prices, but stability is a start. If we do not get there soon, we may be facing that service decay foreshadowed by the e-mailer.
Tougher and tougher calls are being made by vendors and suppliers about the platform and component solutions they are going to support in the coming months. We are hearing more reports of carriers with network hot spots and how hardware is being relocated around networks to deal with these problems. This approach can only take a carrier so far before it faces service issues and potential customer defections. Carriers will be forced to make some of the same tough decisions being made by suppliers. The first step is apt to be on the pricing front. To this point we have not heard a murmur of firmer industry pricing; however, two years of severe spending cuts and working off slack capacity as well as the risks associated with older generations of equipment seem to be setting the stage for something soon.
Was Agere Systems' departure from the optical arena the right move? The short answer in our view is yes. The story investors would expect to hear from a seller of these assets is that the market is not apt to recover in a material fashion for some time to come and that the seller has better opportunities elsewhere—just as Agere management reasoned when its decision surfaced. The truth is that the same people who see no light at the end of the tunnel for the optical markets today saw no clouds on the horizon two and a half years ago. So our approval of the move has nothing to do with the prospects for the market.
We believed that Agere was among the best-positioned companies to challenge JDS Uniphase for industry leadership in optoelectronics. Certainly, demand is questionable in the intermediate term, but very few people we know question that there is a favorable trend for optical content in communications equipment over the next several years. At the same time we face that positive trend, the venture-capital community has reduced its interest in funding startups in the sector, and major companies have begun to withdraw from the business in the most extreme examples or at least have seriously curtailed their R&D efforts in the more tame instances. One of the few players investors see building its presence in the sector is Intel, but even there we feel the moves have been fairly modest. That strikes us as a favorable competitive backdrop and begs the question, why would investors approve of Agere's decision?
Agere's opportunity to capitalize on the current market conditions has been encumbered by its birthright, in which it inherited more than $2 billion in debt and faced restrictions on its ability to issue new equity as an outgrowth of the IRS's approval of the spinout as a tax-free event. Those restrictions put Agere in the position of navigating the current environment with reduced flexibility and hurt Agere's ability to fund the acquisitions of potentially attractive assets that have begun to show up on the market. Therefore, Agere was faced with internally developing products for its target markets or funding acquisitions through internally generated cash.
These limitations force the issue that the company should only compete where its market positions are strongest and the outlook for its addressable markets are most certain. That area was not in optics, at least not for the next 12 months. Couple those conditions with investor desires to see profits ASAP, and we are hard-pressed to argue with management's decision.
Something very important happened this summer for the optical-component industry. At a minimum, we think that short-term investors in Agere came away winners. The optical-component industry lost a major competitor and may be better off because of it. We think this sort of event will help put the optical-component industry back on the road to recovery sooner than if Agere had maintained its course.
Kevin Slocum is a managing director and head of communications research at SoundView Technology Group (Greenwich, CT). He has more than 20 years of financial industry experience, including institutional equity research sales and analysis, and has been named to the Wall Street Journal's prestigious "Home Run Hitter" list two consecutive years. He can be reached at 203-321-7200 or [email protected].
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