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The End of Telecom As We Know It And I Feel Fine

rem.jpgAnyone know where the next ten-bagger investment is in the Telecom sector? Does anyone believe such an idea is even possible anymore?

I feel like I am turning up good scenarios where companies are tactically or structurally overvalued. I feel like I’ve found good value plays in the tech sector, particularly if my consolidation models work out. I can even reconcile the valuations of big companies like Microsoft (MSFT), Broadcom (BRCM), and Intel (INTC) based on the enormous opportunities that exist as more sectors of the economy and more segments of our lives transition from analog to digital.

But at the end of the day, there seems to be a lack of home-run ideas in Telecom infrastructure. I challenge anyone here to name a publicly traded Telecom component or equipment company that will be worth 10x what it is today in five years based on fundamental growth. Another way to look at it – name a public company that will increase revenues by 10x without eroding margins.

It was not always this hard. Where do the big 10x opportunities exist in the telecom & communications sector today? Nothing jumps out, at least to me.

I think it is pretty clear the whole industry is ripe for some major disruption. Rather than be pessimistic, it’s time to be optimistic, and identify what trends could reverse the industries fortunes.

Let’s look at the key ingredients for stratospheric growth.

  1. Relatively small market cap today. It’s a lot easier to grow from $1BB to $10BB than it is to go from $10BB to $100B. So throw out many of your household component and equipment names.
  2. Defensible concept. Optical module makers like Finisar (FNSR) and Avanex (AVNX) may be a big and vertically integrated but as of today there are few barriers to entry. Toss out most of the component vendors.
  3. Fat margins. Usually the result of #2. Intel, Broadcom, Cisco (CSCO) are good examples.
  4. Sticky. Once embedded, can’t be cleansed. Microsoft Windows. Your home phone number. The first email address you used widely. It’s hard to throw out a Broadcom Ethernet switch because the software investment, not the silicon itself.

Yeah, yeah, I know it’s a Five Forces ripoff.

It is exceptionally hard to identify existing communication infrastructure companies that meet these criteria. Many opportunities exist for 2-3x valuation based on consolidation. But where is the home run based on growth, and not decomposition? A critical look at the criteria above bring to mind a software company, not a hardware company.

It is increasingly clear to me that the growth opportunity in Telecom is going to be on the software side, not the hardware side.

Much like sexy big-iron computing hardware was commoditized into a common platform by Microsoft, sexy big-iron Telecom will follow the same path. The worst offenders appear to be specialty hardware boxes for specific applications, like Video Servers, Core Routers, or softswitches. Why not buy a few racks of bladeservers that can do all of the above?

When I think of Telecom companies today, just like analysts in 1980 thought of computers, I think of tricked out hardware. But there appears to be much more upside in turning communications equipment in a commodity and moving the value into software.

People think of Cisco as a hardware company. Take away 25% of Cisco’s operating income from marking up optical modules, and look at where the value really is. It’s IOS, the software that welds together all of their systems. The hardware exists only to monetize that software monopoly. Maybe they should just sell the software and let Huawei/3Com (COMS), HP (HPQ), and Dell (DELL) kill each other building the hardware.

Today, I can name 5 communication hardware companies for every software company. In 10 years, I expect this will invert. I intend to start focusing more of my time to understanding this transition.

Inspired by Martin Geddes excellent post “IMS is just an application“.

Discussion

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  1. If its software, where does open source fit in?

    Posted by eugene rudkevich | September 25, 2006, 5:03 PM
  2. Posted by Andrew Schmitt | September 25, 2006, 5:05 PM
  3. Great article. Martin Geddes is sharp.

    I agree and the one software company that I can recommend is Global IP Sound out of Sweden/San Francisco. They currently trade on the Norwegian OTC. It’s a bit of a hassle, but it’s worth the trouble. They make critical sound components for VOIP. Customers include Nortel, Google, Skype, Microsoft, Yahoo, and on and on.

    Posted by Rick | September 25, 2006, 11:17 PM
  4. I’ll check it out.

    I spoke to a Nortel engineer this summer who said that managing echo and voice quality through their PBXs was a nightmare. Sounds like good functionality to outsource.

    Posted by Andrew Schmitt | September 26, 2006, 2:26 PM
  5. Well, at least someone swallowed the IOS cool-aid. They are smart enough to know where the value is but not good enough to get there. It will NEVER happen.

    Posted by Bill Baker | September 26, 2006, 5:44 PM
  6. I think you are confusing two separate issues:

    1.) Where can you find 10x revenue growth in the telecom food chain today?

    and

    2.) Where can you find a telecom food chain investment that can go up 10x in five years?

    In normal times, the answer to (1) is a lot easier than the answer to (2). Predicting fundamental developments is usually a whole lot easier than making money off these developments because the stock market is a fairly efficient discounting mechanism. Show me a company poised for explosive revenue growth and I’ll show you a company that’s got a premium valuation in the market that on some level reflects the consensus expectations of the best minds in the business. Or, at least most of the time I will.

    But it’s been anything but normal times for telecom. When was the last “normal” year for this industry? Stick a gun to my head and I’ll say 1998, but that’s just a guess. What were you doing in 1998?

    Let’s revisit for a moment the bubble year of 2000. Pick a stock, any stock. They were all at valuations so outlandish that one could confidently say they were all going down and going down a lot. (Another case where predicting change in the abstract is a lot easier than making money off the notion.)

    So, I pick JNPR. For the first quarter of 2000, the company reported about $64mm in revenues. At the time, it sported a market cap approaching $50 billion. How could it, in the fullness of time, not go down? Everyone knew it had a bright future, but what possible developments could make the company worth $50 billion? So it’s 6 years later and JNPR has pretty much grown revenues tenfold, but what do investors have to show for it? Not much, as the share price is down about 95%.

    We’re at the opposite extreme now. Lot’s of companies are still down 95% or more from the peak. Some of these are fairly valued and some are cheap. Investor interest in technology is at a low ebb, which means it is a good time to pick and choose where you think the winners will be. Just as importantly, enough time has passed, and enough excesses wrung out, that the average person can probably start to envision better times. Lots of stocks are cheap, and that’s an important starting point for making ten times your money.

    Finding a stock that can appreciate tenfold is not about finding a company whose revenues will go up tenfold. It’s about finding a stock whose price is sufficiently dissociated from its value, and where there are positive fundamental developments that can cause investors to reassess the value. This requires looking at the nexus of valuation, fundamental change and investor sentiment.

    And it’s not just about the tenfold gain either. Risk plays a big role as well. After all, what’s the point of trying to make tenfold if failing means a total loss of capital?

    So, with all the above in mind, I would suggest that there are a lot of opportunities, if only because of low prices and a general lack of investor enthusiasm. Of course, this is opposite to the perceived wisdom, but this is the way it has to be. In 2000, how many people would have said that the average telecom equipment stock would fall 90%? In 2006, how many people will stand up and say that the average telecom equipment stock will provide superior investment returns?

    Telecom is undergoing a period of unusual change, and anyone who is reading this blog knows what I mean. My question is, why shouldn’t there be wonderful investment opportunities?

    Posted by Herb Chen | September 26, 2006, 8:03 PM
  7. Take a look at Lnop. Their EZchip NP-2 “appears” to be gaining traction within Juniper’s full series of routers, from the T, M and E series. I believe Lanoptics has a chance to become “viral” in a couple of tier-1 telcom infrastructure companies as 10gig spreads throughout all ethernet based systems.

    Posted by jb bush | October 7, 2006, 4:09 PM
  8. VOIP is still at its embryonic stage in terms of growth potential. Market such as China, Vietnam, India, South-America represent a huge pool of new customers for converged integrated networking solutions which now offer more features at a fraction of the cost of traditional telephony.
    While Andrew Schmidt is right in seeing a bright future in software, he is mistaken in assuming hardware innovation has bifurcated into a dead-end. Why, research is already well under-way for holographic 3-D projections of the party you’re talking to as well as of any other selected objects be it a financial chart, a DNA helix or a Pussy-Cat Dolls video.
    There is also research being done for 3-D virtual reality communications with touch sensors and olfactive input. Meaning the interaction of the touch and smell senses in conjunction to the more common sound and sight features.
    Do not forget, technology does not follow a linear path. It is chaotic in its behavior and proceeds by hops and leaps.
    Now, to leave the realm of speculative fiction and descend to that of speculative trading for the sake of argument, please indulge me and examine the prospects of 3COM. Here’s a company widely hated by analysts and a great number of disgruntled shareholders due to its poor performance and awful past management. It is now trading close to its ten year low. My argument is that the market’s perception of this company is biased and distorted due to past injuries. There is still plenty of trauma and irrational suspicion vis-à-vis what is essentially a very strong company which has re-invented itself. The fact is, the incompetent staff has left three years ago and effectively been replaced by a far better one. It takes time to turn a big ship such as 3COM around but they have managed to do so in less than 3 years. The fundamentals look solid. It is now the 2nd largest networking company in Asia. H-3C has experienced a 70% year over year growth for the last 3 years. Unlike CSCO, it has plenty of room to improve its profit and revenue margins. It is now grossly undervalued, trading at about 1.5 times revenues while CSCO is trading at more than 10 times revenues. Once the veil of negativity is lifted and investors pick up on growth momentum, the stock price should comfortably reach 8 dollars over the next two years. That’s more than a 100% profit.
    The market is an emotional beast. But a company with strong fundamentals and selling quality products in an expanding market will always prevail in the long term.
    Cheers and good luck :)

    Posted by Penelopium | March 13, 2007, 8:53 PM
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