By Neal Weinberg

04/23/01

When Cisco misses earnings projections and announces layoffs, you know the outlook for other network players can't be good.

Still, the horizon in 2001 is not all doom and gloom. The prognosis varies by sector. Here's our annual forecast of how the year will pan out for three critical enterprise segments: carriers and ISPs, infrastructure and enterprise applications.

No matter what company you work for, just be thankful you're not at a competitive local exchange carrier, especially a data-centric CLEC trying to sell DSL service. And if you're thinking about buying DSL service from a pure-DSL CLEC, you'd be advised to think again.

The list of CLECs filing for bankruptcy is long and getting longer by the day. Members of this not-so-elite group include American MetroCom, Axessa Communications, GST Telecommunications (acquired by Time Warner), ICG Communications and NorthPoint Communications. In fact, stock pickers for some of the major telecom mutual funds have pared the CLECs in their portfolios down to only four or five companies that look like good long-term bets. And those companies have one thing in common: They get revenue from voice, Web hosting and other sources besides DSL.

Venture capital funding, which DSL CLECs need to build out their networks, has dried up. These companies are not profitable and they don't expect to be so until 2003 or 2004. And Wall Street is not in a patient mood. Covad Communications' stock has gone from a high of $60 per share to less than $1 per share. Rhythms NetConnections was trading recently at 25 cents per share, down from a high of nearly $46 per share.

As if the lack of capital weren't a big enough problem, the CLECs now face a full-scale assault by incumbent local exchange carriers (ILEC). Initially, the ILECs resisted the idea of offering DSL themselves because it would cannibalize their profitable T-1 businesses. Their basic strategy was to make it time-consuming and difficult for CLECs to collocate DSL Access Multiplexer equipment in their central offices.

But more recently, ILECs have decided to take on the CLECs, and have engaged them in a DSL price war. Of course, only the ILECs can win that fight. They've got the existing infrastructure to increase DSL sales quickly and the deep pockets to outlast the CLECs.

During 2000, the number of DSL lines deployed by ILECs skyrocketed from 386,000 to 2 million, according to TeleChoice, a market strategy consultancy for the telecommunications industry. TeleChoice predicts that the total number of DSL lines in service will jump to 5.7 million this year, a 142% increase over 2000. And ILECs will account for more than 80% of that total, according to TeleChoice analyst Adam Guglielmo. In fact, SBC Communications and Verizon have more DSL lines in service than one-time leader Covad, whose business is in shambles. As of early January, SBC had 767,000 lines; Verizon, 540,000; and Covad, 274,000. Qwest Communications, with 255,000, and BellSouth, with 215,000, are catching up quickly, too.

Covad says it expects revenue to reach about $380 million in 2001, but losses to mount to about $460 million. It's burning through cash at $75 million per month, and even though it expects to throttle back spending to $60 million per month by cutting its payroll through layoffs and focusing on a smaller number of markets, the company only has enough cash to last into early 2002. Those are scary prospects for the once-high-flying company that topped the Network World 200 list of fastest-growing companies just last year.

Similarly, Rhythms recently announced layoffs and says it plans to lose $395 million in 2001. It, too, says it has only enough financing to last for another year.

Another problem for DSL wholesalers such as Covad is that some of their customers, DSL retailers, are going bankrupt themselves. Covad announced recently that it wasn't receiving revenue from 92,000 lines, almost 34% of its 274,000 lines in service because it had wholesaled those lines to 19 "troubled" ISPs. At least four of those - FastPoint, Flashcom, Relay Point and Zyan - have filed for bankruptcy.

Some analysts believe ILECs, primarily Qwest, SBC and Verizon, will simply use their size to crush the vast majority of CLECs. During this shakeout, a rash of activity is likely, with weak players going under or being bought out, either by stronger CLECs that want to expand their reach or by non-CLECs that want to enter the market.

When GST of Vancouver, Wash., went under, Time Warner bought its assets at auction (360,000 access lines, 4,200 miles of fiber optics and 15 voice switches) and created Time Warner Telecom. Allegiance Telecom, a CLEC in Dallas, recently bought InterAccess of Chicago. And AT&T last month bought NorthPoint's assets, including points of presence in 109 cities and towns, at a bankruptcy auction for $135 million.

Analysts have identified a handful of CLECs that have strong enough management teams and enough capital to survive until the economy picks up. That list includes Allegiance Telecom, which also recently bought Web hosting firm HarvardNet; McLeodUSA; Time Warner Telecom; and XO Communications. These companies all derive revenue from voice traffic, VPN and Web hosting, in addition to DSL.

Another storm cloud has appeared on the CLEC horizon in the form of Michael Powell, the new Federal Communications Commission head. Under the Clinton administration, the FCC would not let ILECs into the long-distance market until they demonstrated that competition existed in the local market. ILECs were, in effect, forced to play ball with the CLECs. Powell has indicated that he would look favorably on ILECs entering long-distance markets without having to first prove local-loop competition.

"If the FCC does not provide regulatory pressure on the traditional market providers, that could be the final nail in the coffin [for CLECs]," says Robert Rosenberg, an analyst at Insight Research, a market research firm for the telecommunications industry.

The FCC's new stance could shift the balance of power in the carrier market against traditional long-distance voice carriers in favor of powerful ILECs such as SBC and Verizon, Rosenberg says. If ILECs get ready access to long-distance, they'd quickly become formidable competitors to AT&T, Sprint and WorldCom with their local/long-distance combos.

Even without competition from the ILECs, the long-distance carriers are in trouble. Price wars have squeezed the profits out of long-distance voice, an already slow-growth market.

AT&T says it expects flat revenue from business long-distance in 2001, while margins will shrink as a result of continued price pressure. And, the company says, consumer long-distance revenue will drop nearly 20%, also with shrinking margins. Based on those factors, as well as the economic downturn, Morgan Stanley Dean Witter predicts AT&T's earnings from its business and consumer long-distance divisions will drop roughly 26% in 2001 compared with 2000. AT&T won't comment on the forecast, but has acknowledged that it needs to show strong growth in Web hosting, Internet access, frame relay, wireless and cable.

The situation at WorldCom isn't much better. WorldCom predicts that revenue from its voice-centric MCI group will fall 2% in 2001, while its data-centric WorldCom group will grow 12% to 15%. WorldCom's strategy is to use the cash that the consumer voice business generates to finance data and Internet investments.

Insight Research predicts that total long-distance minutes will increase only 2.5% in 2001. And Rosenberg says telecom won't bounce back "until we see a continued uptick in consumer confidence," and nobody can predict when that will occur.

Of course, this is all bad news if you're holding AT&T or WorldCom stock. But if you're negotiating a new contract for voice, data or Internet services, you could find some excellent deals out there.

The shakeout in the CLEC market and overall slowdown in service provider spending is having far-reaching ramifications. Take the case of a small CLEC named Digital Broadband Communications and its dealings with Cisco.

In February 2000, Digital Broadband announced it was buying $20 million worth of Cisco optical gear to build out its network. But the firm was more than just another Cisco customer, it was a recipient of Cisco's largess, having previously secured an $85 million loan to buy switches and routers from the vendor. So, when Digital Broadband went belly up several months later, Cisco lost not only a potential customer, but also its loan.

The failure of CLECs, compounded by the downturn in service provider spending, is a major reason Cisco expects 2001 to be a difficult year. In fact, Cisco's sales to CLECs in its latest quarter dropped 40% year over year to $300 million.

Cisco gets 40% of its revenue from service providers, which are accustomed to long sales cycles, deep discounts and vendor financing. "The types of customers that Cisco tends to finance are ones that cannot receive financing elsewhere, implying that Cisco is taking on risk where others won't in order to complete a sale," says Seth Spalding, an analyst at Epoch Partners, an investment bank.

Of course, Cisco's level of involvement in service provider financing ($475 million) pales next to more-established telecom equipment makers. Nortel Networks has $1.8 billion worth of vendor financing on its books and Lucent has $1.3 billion.

And while the most recent quarter was disappointing by Cisco's standards, any of the vendor's major competitors would kill to be in its position.

Take Nortel. In January, it projected that earnings for 2001 would increase by 30%. In February, it abruptly downgraded that estimate, saying that 2001 earnings would be up only 10%, and announced plans to lay off 10,000 workers. Then in March, it threw another 5,000 into the layoff pool. (To give you some idea how traditional networking companies differ from traditional telephone company hardware suppliers, Nortel has 94,500 employees vs. Cisco's 34,000.)

Nortel CEO John Roth has since repealed all growth projections and stopped issuing new ones, after the ebullient statements in January and February incited investors to launch a flurry of class-action lawsuits (See related story).

 Last month, Nortel announced that its first-quarter results will be worse than expected because the U.S. economy continues to weaken and that weakness is spreading overseas. Nortel had estimated revenue of $6.3 billion, but now says revenue will be between $6.1 and $6.2 billion, which analysts translate into a net loss for the quarter of between 10 cents and 12 cents per share. Roth has said that the slow U.S. market will likely drag Nortel down well into the fourth quarter.

And Lucent is in total disarray. In December, the once high-flying AT&T spinoff announced losses of more than $1 billion on revenue that dropped 26% from the previous year. Lucent blamed the losses on the decline in the CLEC market, a slowdown in capital spending by established service providers and investments in CLECs that didn't pan out. The company announced a restructuring plan that would slash 10,000 jobs, or 8% of its workforce.

Nonetheless, Lucent stock went from a 52-week high of $70 per share down to around $7 per share. Standard & Poor's and Moody's Investment Service downgraded Lucent bonds from A- to one level above junk bonds, reflecting concern about Lucent's chances to return to near-term profitability.

The story at 3Com is similar. In late February, it said it would lay off 1,200 employees, because of the economic downturn and weakness in the telecom industry. In March, 3Com reported third-quarter revenue down 18% from its second quarter, and a $223 million loss. After it announced those results, the company said it would drop its consumer Internet product line and make additional cost-cutting moves.

But all is not bleak. Cisco's third quarter sales will be 30% lower than second quarter sales, but the company still expects to turn a small profit. And CEO John Chambers predicts long-term growth in the range of 30% to 50%. While Cisco's cash and investments declined by $1.6 billion as a result of those private equity deals with CLECs that failed to produce any gain, it still has $18 billion in cash and investments to throw at research and development, acquisitions and product development.

It has dominant market share in routers and switches, a top-notch sales force and excellent management, and is staking out a leading position in new market areas such as voice over IP and wireless. The next few quarters will be "the ultimate test of these key strengths" for Cisco, says Bill Lesieur, an analyst with Technology Business Research, a market research firm.

And, in spite of the CLECs' problems, market research firm Infonetics Research predicts that sales of network equipment to service providers will jump 72% to $24.4 billion this year. That's down from the 118% growth rate last year, but it's still healthy. "There are some service providers going out of business, but there are more entering the market. And the Tier 1 service providers still need to buy equipment to keep up with customer demands," says Kevin Mitchell, an Infonetics analyst.

Customer relationship management has dominated the enterprise software market for the past couple of years. The upswing came first as companies bought CRM software to automate their help desks or sales staffs. It continued as companies moved to eCRM software to improve the customer experience on their electronic-commerce sites.

CRM revenue hit $4.4 billion in

1999, then jumped 54% in 2000 to $6.8 billion, according to AMR Research, a research and analysis firm. But AMR predicts the growth will slow a bit this year, to about 44%, for revenue of $9.79 billion.

The bulk of CRM revenue comes from extremely large companies, says Jim Shepherd, an AMR analyst. "There's an understanding on the part of senior management that you can use technology to retain customers, and it's clearly less expensive to hold on to the customers you have than to get new ones," he says. "And there's an understanding that changes in technology have made customers more demanding."

The economic slowdown means only that companies will be more picky about the CRM software they choose, not that they'll stop buying it, says Kirsten Cloninger, an analyst at Cahners In-Stat Group, a market research firm. "The enterprise market will continue to plow ahead and implement solutions to manage customer relations, as well as supplier and partner interactions. CRM is a strategy more than a technology - in other words, it's a must-have," she says.

Siebel Systems is clearly the dominant player. It posted revenue of $1.8 billion in 2000, up from $814 million in 1999, and profits of $123 million, up from $57 million. Other top players include Art Technology Group, Aspect Communications, BroadVision, Dendrite, Nortel (through its acquisition of Clarify), Oracle, PeopleSoft, SAP and Vignette.

Of course, no matter how well-positioned a company is, it's not immune from a severe economic downturn. Robert Austrian, an analyst at Banc of America Securities, recently downgraded his earnings estimates for a slew of companies, including Siebel. He trimmed his estimate of 2001 software license revenue for Siebel from $1.72 billion to $1.68 billion.

The CRM trend for 2001 will be for vendors to broaden their applications suites through alliances and partnerships. CRM purchasers should look for vendors with a broad range of products, rather than a vendor with a single point product.

Related links

Caution flags flying as CLEC woes mount
Network World, 11/20/00

Optimism remains despite DSL flame-outs
Network World, 01/22/01

DSL providers' bloodbath continues
Network World, 12/11/00

A Dickensian industry
The Edge, 03/14/01

Lucent takes some more heat
The Edge, 04/06/01

Vendors, users grapple with CRM shakeout
Network World, 04/16/01

Company profiles
BellSouth
Cisco
Covad
Lucent
Nortel
Oracle
PeopleSoft
Qwest Communications
Rhythms
Verizon
XO Communications
3com

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