Capex Continues To Surprise On the Upside

A key fundamental driver of the communications equipment industry and associated supply chain stock performance is the growth in overall capital spending by service providers, including wireless, fixed and cable TV operators.  Coming into 2014, the general expectation by Wall Street analysts was for 2014 to be a decent year of overall growth in capital spending on the order of 2%-4%, with the wireless component growing much faster in the 6%-9% range. The 2014 growth expectation was due to a ramp in spending in key markets like China given the expectation that LTE would be finally rolled out in earnest, Europe given operators were expected to start growing spending after a period of under-investment in the past few years and the US given wireless operators were expected to continue to grow spending to enhance network quality and expand LTE coverage.

After reviewing some of the key telecom operator 4Q13 results in these regions and their respective comments on capital spending plans for 2014, the general bias on 2014 capital spending by operators was generally to either maintain or raise capex expectations.  In addition to expected capex spending growth in wireless I mentioned above, we also heard better spending plans in fixed networks in the US from the larger three cable TV operators and in Europe by traditional fixed operators.

I continue to view the upward bias on 2014 operator capex as favorably for communications equipment and supply chain companies.  While several companies may benefit from this trend, I continue to favor Alcatel-Lucent (ALU) and Finisar (FNSR) as stocks to benefit from this theme.  Both are beneficiaries of the upward bias on capital spending while Alcatel-Lucent has the added benefit of a restructuring story and Finisar has the added benefits of relatively higher exposure to the optical upgrade in China and ramping deployments of “white box” switches by Web2.0 companies (e.g. Amazon) that utilize their optical sub-systems.  Keep in mind, both ALU and FNSR are very volatile stocks and can have extreme negative reactions to any negative earnings or other negative macro-economic and fundamental news.  In particular, Finisar reports earnings this week and Alcatel-Lucent has exposure to emerging markets.

Here are some key highlights of recent capital spending commentary from key operators in the US, China and Europe from 4Q13 earnings calls that took place in January and February:

China: After a delayed tendering process by China Mobile in 2013 for LTE equipment suppliers, a portion of China Mobile capital spending was delayed into 2014.  This deferral into 2014, combined with all the major operators ramping LTE spending in 2014 is likely to lead to an overall China capex growth of 15% in 2014 vs. prior expectations of about 10% growth.

US – In the US, AT&T, Verizon, T-Mobile, Comcast, Time Warner Cable and Charter all raised their respective 2014 capex plans vs. prior analyst expectations.  In addition, Google announced it is planning to expand its Google Fiber network to 34 additional cities in the future, which may add to the competitive pressure in residential broadband networks in future years.  Specific capex commentary from above mentioned US operators are as follows:

–       AT&T: Announced Project Agile that will result in capex being about $21B in 2014 vs. prior estimates of about $20B

–       Verizon: Guided 2014 capex to $16.5B-$17.0B vs. prior estimates of $16.0B-$16.5B.

–       Time Warner Cable: Guided 2014 capex to $3.7B-$3.8B vs. prior estimates of about $3.2B-$3.3B given new initiatives such as all digital conversion.

–       Comcast: Guided 2014 capex about $800M higher than 2013 given initiatives around digital set top boxes and WiFi routers.

–       Charter: Guided 2014 capex higher than expected by about $400M primarily due to all digital conversion resulting in 2014 capex of about $2.2B vs. prior estimates of about $1.8B.

Europe – In Europe, there continue to be early signs of a need for network operators to upgrade their networks after a period of cautious investment in the past few years.  The two most notable examples were Vodafone and Telefonica.  Vodafone announced Project Spring in 4Q13 that will result in capex of about £7.3B in 2014 vs. £6.2B in 2013.  Telefonica raised its expected capex/sales ratio for 2014 to 15.5-16% compared to 14.5% in 2013 to fund new network upgrade programs.

 

Are Optical Component Stocks In Trouble?

While I continue to think there is a decent chance in a capital spending recovery in 2013 that should help telecom infrastructure suppliers like Ericsson and Cisco, I am not that positive on optical component companies like JDSU and Finisar.  The main reason for this is technology dislocation risks that are surfacing that might reduce the role traditional optical component companies play in networks.

This past week, Intel announced collaboration with Facebook on its developments efforts in silicon photonics, a new technology that uses less expensive silicon rather than the traditional more specialized materials used in optical materials. Intel and Facebook see silicon photonics as a way of dramatically reducing the cost and simplifying the design of rack architecture within the data center.  A quote from the press release on the silicon photonics technologies is shown below:

“… the new architecture is based on more than a decade’s worth of research to invent a family of silicon-based photonic devices, including lasers, modulators and detectors using low-cost silicon to fully integrate photonic devices of unprecedented speed and energy efficiency. Silicon photonics is a new approach to using light (photons) to move huge amounts of data at very high speeds with extremely low power over a thin optical fiber rather than using electrical signals over a copper cable. Intel has spent the past two years proving its silicon photonics technology was production-worthy, and has now produced engineering samples.”

In addition to these efforts by Intel on silicon photonics, Cisco acquired a private company called Lightwire in March of 2012.  Lightwire was developing advanced optical interconnect technology for high speed networking and Cisco viewed the enabling technology as a way of owning more of the optical subsystem technology within their products while also using a newer, lower cost design implementation than traditional transceiver technology purchased from optical component companies.

I believe efforts by Intel (and others) in the emerging field of silicon photonics and Cisco’s efforts in owning more of the optical value chain in their products does not bode well for traditional optical component companies.  While any telecom capital spending recovery would lift all boats (including optical components companies), the technology dislocation risk posed by silicon photonics and efforts by OEMs like Cisco post longer-term risks for optical component stocks.  It will be interesting to see if traditional optical component companies seek to invest in silicon photonics to protect their traditional businesses.

Disclosure:  I currently own shares of Ericsson and Cisco mentioned in this blog post. NT Advisors LLC may currently and in the future solicit any company mentioned in this blog post for potential consulting/advisory work.