Telecoms Tech

By Matt Walker, Principal Analyst, Networks & Technology

Summary

Hard times continue for telecom infrastructure vendors.

In the past week, two of the top six suppliers – Alcatel-Lucent (#4) and ZTE (#6) – have warned of disappointing 2Q12 earnings.Ericsson’s 2Q12 earnings were much weaker than expected. Another top vendor, Nokia Siemens Networks, is making major staff cuts, spinning off assets, and suffering predictably challenging morale and customer reactions.

Huawei and Cisco appear stronger, but no company is immune to this “sustained period of macroeconomic uncertainty and volatility in the global economy and in capital markets,” as Ciena described it in its 1Q12 10Q filing.

It’s not just the economy. Vendors’ customers, the network operators, are facing severe threats to their core revenue base from OTT players – that will not make them loosen the capex purse strings.

But the industry will come out of this mess alive. IT, software, apps, and services will be more crucial to network value, and the network operators will still need their vendor partners. Mergers and acquisitions (M&A) will likely play a key role.

Immediate reasons are CDMA plateau, weakness in China

ZTE’s warning cited weakness in China and foreign exchange losses. Neither factor is under the company’s control. The global economy’s frailty is simply spilling over into China.

Chinese carriers have high capital budgets by global standards, and despite government enticements they will come down. Ovum’s December 2011 capex forecast predicted China’s capital intensity (capex/revenues) would decline from 26% in 2011 to 21% by 2015.

ZTE may be hit harder, though, due to its exposure to CDMA, which is ebbing in many of its major markets. The effect is likely stronger in China because of TD-LTE.

CDMA is also an issue for Alcatel-Lucent. Its official warning was generic, but North America in general and CDMA EVDO specifically are likely contributors.

George Notter from Jefferies, for instance, estimates that EVDO Rev A/HSPA+ software sales generated about €1bn in operating profit for Alcatel-Lucent in 2011, putting the vendor at risk of erosion in this market. This is happening now, as North American carriers deploy LTE.

Alcatel-Lucent has a good position here, but revenue recognition from LTE is incremental over time, as both features and capacity are driven more by software loads.

Ericsson’s 2Q12 actual earnings, released July 18, were consistent with the warnings from ZTE and Alcatel-Lucent: its networks revenues dropped 17% from the year-ago level, due to “the expected decline in CDMA equipment sales” and weakness in China and Russia.

Smartphones soaking up industry growth, but this is unsustainable

In our forthcoming report Telecom Vendors’ Earnings and Strategy – 1Q12 Review and 2H12 Outlook, we find that device revenues for the key vendors in 1Q12 amounted to $59bn, up 25% from the year-ago quarter.

Revenues for the key semiconductor suppliers to telecom vendors grew 13% over the same period – still a healthy rate. And Qualcomm, probably the chip vendor most exposed to smartphones, saw revenues grow in 1Q12 by about 21% after removing acquired assets (Atheros).

Further, Qualcomm is one of the few vendors in the telecom universe, other than perhaps Huawei, in expansion mode. Yet vendors’ revenues for network infrastructure and related services declined by 4% in 1Q12 to $37.9bn.

So: smartphone adoption is driving related chip and device revenues up at a healthy clip.

But the vendors building the networks aren’t benefiting, at least not now. And service providers continue to struggle on the revenue front, often subsidising smartphone purchases and then seeing users adopt OTT apps such as WhatsApp, Tango, and many others to bypass the operator.

This is an unsustainable balance for the industry. For this reason, Ovum is publishing extensively on OTT; on the carrier side, see for instance Counteracting the Social Messaging Threat (July 2012).

Consolidation and streamlining inevitable for vendors

As network access speeds rise and smartphones get more sophisticated, in theory operators should be investing more in network performance and quality of service. But we don’t expect a capex explosion.

There are (at least) a few too many vendors, some too large and spread too thin, and some won’t survive in their current form. Nokia/NSN, Tellabs, RIM, and possibly even Alcatel-Lucent are near the top of this list, but many smaller vendors face similar issues.

Mergers and acquisitions (M&A) is never easy and often fails. But short of quitting the market, it is the best choice for some of these names. A number of smaller deals have been announced over the past few quarters, including Syniverse-Mach, Avaya-Radvision, Motorola-Psion, Ixia-Anue, Spirent-Fanfare, F5-Traffix, Sonus-NET, Arris-BigBand, and Ericsson-Belair.

The optical components sector is also consolidating, albeit slowly, with combinations such as Finisar–Red C, Cisco-Lightwire, NeoPhotonics-Santur, and Oclaro-Opnext.

Pulling off the larger deals, which are still needed, will be tougher and take longer.

One likelihood is more cross-sector M&A, such as last year’s Google-Motorola deal. After all, telecom-focused vendors don’t have the deepest pockets in the tech industry – those belong to vendors selling software, IT, handsets, and consumer electronics. Microsoft alone, for instance, has $59.5bn in cash and short-term investments as of March 2012, more than 5x that of Ericsson.

Ovum predicted in 2009 that the 2020 telecom market would be dominated by “SMART” players, who have a “multiplicity of origins: software vendor, broadcaster, content provider, consumer electronics vendor and webco, as well as telco.”

This evolution is well under way. The supply side of the telecom industry now needs to realign itself with the requirements of these new power players.