China's Telecom Spending Weakens, is Telco Threatened?
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China’s ZTE Corp surprised the market with a grim pre-announcement on Friday and the Hong Kong-listed stock was the latest in the telecom sector to crash on Monday. Whereas other stocks in the sector have disappointed on weakness in North American service provider spending, part of what ZTE is saying is related to China’s spending. The company makes around 50% of its revenues from telecom network equipment and is a leading player in China. What it says matters.
What did ZTE Say?
The company pre-announced results and stated that profits would be down 60-80% on last year. There were three reasons given for this. The first two relate to a stock-specific issue (a drop in investment income from the disposal of shares) and foreign exchange losses blamed on the depreciation of the Euro.
However, it is the third reason that will interest external investors. ZTE’s targeted growth rate fell short because domestic carrier networks postponed some contract tendering. At the same time there was a decline in the overall gross profit margin. The two are likely to be correlated and should be seen as symptomatic of a weaker spending environment. In a slowing environment many companies will be faced with rising inventory or high operating costs (due to being geared to higher expected sales) and this usually presages price cuts in order to keep market share, reduce inventory or keep assets ticking over.
This is not just restricted to China. If Huawei or ZTE are having trouble in their domestic market than I suspect companies like Cisco (NASDAQ: CSCO) will start to feel it in its core developed markets. Chaos theory and butterflies flapping in China and all that.
When Will the Spending come back and why does it Matter?
As ever, some analysts are predicting a bounce back with China’s telecom network spending in the second half. This may turn out to be wishful thinking.
It seems that the telecom equipment suppliers have spent the most part of 2012 talking about weakening sales but pinning hopes on a rebound in China’s spending. In particular, China recently announced a $58 billion stimulus package to invest in telecom infrastructure so the bulls have a strong case. China certainly has the firepower to support more spending, but investors need to look at the economy on the whole. It has been weakening recently and the full consequences of a housing market slowdown are certainly not felt yet. Will China actually invest in telecom infrastructure if the rest of the economy is slowing?
As ever with China we need to look at fixed asset investment.
It is definitely moderating and it should be noted that this type of investment tends to be long cycle. In other words, the graph is showing us where the economy was with a time lag. The likelihood is that the trend is getting worse.
This isn’t just bad news for the likes of ZTE and its domestic rival Huawei, it also spells trouble for a company like Cisco which has been trying to expand sales in China. Similarly, telecom equipment suppliers like Finisar (NASDAQ: FNSR), Ciena (NASDAQ: CIEN) and JDS Uniphase (NASDAQ: JDSU) have all talked of a stronger second half, but with every profit warning and negative outlook this is increasingly looking like a "jam tomorrow" story.
We know that North American service provider spending has been weak and despite the verbiage from the likes of Verizon and AT&T there are little signs of an imminent recovery. Now China seems to be going in the same direction. Moreover, it is not just weakness in wire line versus wireless; it appears to be broad based.
A Mixed Picture
Whilst the weakness is broad based, the trends in telecom spending are varied and this provides challenges for equipment suppliers. The mature GSM markets tend to be higher margin, but the growth is likely to come from 4G-LTE & wireless spending. This has consequences for the bottom lines of many telecom companies as changes in the sales mix can affect profitability. Indeed, in certain emerging markets the pressure to upgrade directly to 4G is likely to cause some initial rollout delays and a "spending gap" as they delay 2G/3G spending and wait for the timing to invest in 4G-LTE.
It is inevitable that carriers will start investing again but, as ever, it is a question of timing.
So What Next for the Telecom Companies?
Frankly with a declining end market, none of them look safe. Cisco’s story is one of strength in its periphery offerings, but its core routers division put in a weak performance in the last quarter. With ZTE and Huawei already seeing difficulties in their domestic markets, they are likely to step up competition with Cisco in North America. Moreover, it’s hard to see how things could have got better overall for Cisco because its last commentary was mainly about weakness in Europe.
Ciena provides a relatively better outlook because of its strong position in the 100G market. Finisar has had four straight quarters of negative growth in its telecom revenues and has already spoken of the unpredictability of China’s spending plans. Its rival JDS Uniphase is seeing things a bit better, but it too is probably relying on a second half pick up.
In conclusion, I don’t think China’s spending (what they do, not what they say) will be divorced from the trend of its overall economy. In addition, North American service providers remain cautious and Europe is enthralled in its own political and economic difficulties. On a more positive note the demand for bandwidth, mobile and next generation networking is a secular growth trend so the pressure will be building up. It is a question of timing and right now I think investors need to be patient.
SaintGermain has a position in Cisco. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.