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• Shaker Investments believes that the equipment telecommunication sector is experiencing a temporary slowdown, but that the long-term outlook is extremely favorable.
• The growth of the telecommunications equipment sector is being driven by the following:
  • Capital spending and revenue is shifting from voice transmission to data services and equipment.
  • End user demand for bandwidth continues to expand as the Internet and its increasingly graphical content grow.
  • The volume of data traffic is growing as a result of increases in the number of users, devices per user, hours online per user and bandwidth demand per user.
• Shaker Investments believes that the recent correction is an opportunity to identify companies that will be long-term winners in the following areas:
  • Optical transport
  • Internet routers and switches
  • Metro transport and access equipment
  • Broadband access
  • Component suppliers to the above.

The telecommunications industry experienced dramatic growth over the past decade, as technological changes coupled with deregulation and a favorable capital environment propelled valuations to sometimes astronomical levels.

However, the last 12 months have seen a reversal of fortune, culminating in concern regarding valuations, short- and long-term growth rates, and carrier and enterprise capital spending (Exhibit 1).

Shaker Investments not only believes that this sector is experiencing a temporary slowdown, as demand catches up with supply, but that the long-term outlook is more favorable than ever. Demand growth is limited only by the availability of bandwidth, and will continue to grow rapidly until broadband access is available to everyone.

Data Traffic Surpasses Voice Traffic

In recent years, demand growth has been driven far more by data transmission, rather than voice transmission.

Over the past century, twisted copper-pair cabling, fiber optic and coaxial cable, wireless transmission equipment and a hierarchy of switches and signaling infrastructure were deployed to accommodate a single application: voice. This point-to-point, circuit-switched network, comprised of over 190 million twisted copper-pair installations in the United States and over 800 million installations worldwide, has evolved to provide 99.9999% reliability (or 31.5 seconds/year of down-time), low latency and value-added voice services such as caller ID and voice messaging. Collectively, this network is called the PSTN or public switched telephone network.

Over the past three decades, overlay packet networks that run alongside the PSTN were developed to support another application: data. With the advent of the personal computer and the especially dramatic growth of the Internet, the volume of data traffic that traverses the network has surpassed voice traffic. Moreover, this trend is likely to continue so that by 2004, over 90% of the traffic on the network will be data (vs. less than 10% in 1995).

Growing Internet Use Results in Costly "Double Builds"

From an access perspective, the rapid growth of Internet usage has not resulted from superior technology. Current Internet access via a 28.8, 33.6, or 56 kbps modem is referred to as voice band or narrowband modem technology. Since its introduction, this technology has become the predominant mode of residential access to the Internet – with over 35 million users (households) in the U.S. In fact, it could be argued that the growth in the Internet is in part due to the widespread availability and use of analog modems.

An analog modem essentially carries data by using the circuit-switched telephony infrastructure, originally designed to handle voice traffic. This is an inefficient use of resources and has several drawbacks. From the carrier’s standpoint, every modem connection requires a dedicated line connecting the user to an ISP (Internet Service Provider). This connection is maintained whether the user is downloading content or doing nothing (e.g., reading a web page). Moreover, the duration of each connection is generally much longer than an average phone call (due both to the length of time spent online and slow transmission rates). Because an Internet connection "occupies" the phone line, many users request a second line. This means added revenue for the carrier, but requires additional capacity at the CO (central office) to handle the extra line(s). Lastly, the performance is limited to a transmission rate of less than 56 kbps.

As the number of users connecting to the Internet through analog modems grew, carriers were forced to build out both their voice and data networks, since an internet connection using an analog modem must pass through the voice infrastructure to get to the data network. This "double" build is unsustainable from a capital, operations and space standpoint. The increased level of capital spending by the carriers over the past decade was in part tied to this issue.