Welcome to network equipment

The aftermath of yet another bout of bloodletting in the network communications industry saw a dazed and confused CEO of a major equipment maker simply throw up his hands in frustration.

Nortel CEO John Roth admits he can’t predict the behaviour of his major customers after announcing yet another financial bombshell in late March, when he warned that his company’s revenues would be weaker than expected in the current fiscal quarter.

Nortel certainly isn’t alone. Cisco Systems has likewise been prepping the financial community for weeks with snippets of news that its financial performance, too, will also fall below expectations, while 3Com recently reported a loss in its fiscal quarter. Welcome to the Great Depression of communications networking.

The current depressed market, particularly in the carrier segment, seems to have completely blindsided network equipment makers and that, frankly, comes as a shock. Companies like Nortel and particularly Cisco achieved tremendous revenue growth – upwards of 35 per cent to 45 per cent annually – through a predictable model. Cisco, for example, prior to missing its financial targets earlier this year, had an incredible string of more than 30 consecutive quarters where it met or exceeded growth expectations. The company has long attributed its stellar success to the intimate relationships it has with customers, which kept them in tune with spending habits. Likewise Nortel was equally tight with its equipment buyers.

When Nortel back in January declared it would not meet projections, blaming reduced capital spending by U.S.-based carriers, industry observers had a difficult time believing the company could so badly misread the market. Industry and financial analysts were skeptical that Nortel and Cisco could not have foreseen the onset of such extreme spending freezes by telecommunications carriers or predicted the disappearance of venture capital funding for communication service start-ups.

But as the news gets progressively worse each month, maybe Roth and Nortel can’t forecast market demand or predict customer behaviour anymore.

In fairness to the beleaguered equipment makers, likely some fundamental changes have occurred in their businesses. Telecommunication carriers in particular have spend enormous amounts of money on network infrastructure builds over the past three years, but seem to be taking a spending breather, possibly to realize some return on all those expensive networks put in place.

Decision making by carriers also appears to be much more arbitrary, in contrast to their typically methodical approach. Spending decisions by these customers suddenly appears to be much more rapid, where budget allocations, which may have taken many months to determine, are being reassessed and changed over the course of weeks.

With all the gloom and doom, reality has been lost. Yes, the communications equipment industry is in the midst of a horrible downturn – the toughest period in recent memory. However, most experts agree this is a temporary situation and undoubtedly the network equipment purchasing doldrums, particularly among telecommunication carriers, will end, and hopefully sooner rather than later. Communication infrastructures haven’t suddenly gone out of style or necessity, and who would argue that networks wouldn’t continue to underpin computing?

We’re witnessing an evolution that will undoubtedly spur change among equipment makers. Those that emerge from the network communications equipment drought of 2001 will be much the wiser, having learned the dangers of focusing on limited sets of customers and relatively few product offerings. Look for much more diversification in the future.

Nortel’s undoing during this difficult year may have been the result of too much emphasis on large U.S.-based carrier customers and voice equipment. Among the most successful Nortel business units these days is its enterprise base, where the Canadian office reports more than 30 per cent year-over-year growth. Unfortunately, because the enterprise represents a relatively small portion of Nortel’s business, such solid performance hasn’t been enough to carry the company through these lean times.

Diversification will be a tough pill to swallow. It generally means much more conservative revenue growth – not the 30-plus per cent that was typical for network equipment makers during the good years prior to 2001. However, downward turns in the market, for a diversified company, would also tend to be much less devastating since slower growth in some areas would be offset by higher rates achieved in other business segments. There’s not the astronomical rise in market capitalization as a result, but business is much less volatile.

A key question is whether Cisco and Nortel could successfully operate on lower market capitalization due to much less aggressive growth? High valuations of Cisco and Nortel stocks have previously served as enabling collateral for acquisitions that have been key to advancing network communications technology. It’s no surprise that the frenzy of purchases by the likes of Cisco and Nortel that characterized the previous three years have ended abruptly due to the modest value of the respective stocks of both companies.

It would seem wise and necessary for equipment makers to proceed with caution once good health returns to the network communications market. Nortel and Cisco have been driven to near ruination by recent events and years of market capitalization growth were lost in mere months.

When a business whose success absolutely depends on accurately reading and predicting the behaviour of the market throws up its hands in frustration, clearly the message is that the current way of doing business cannot continue.