A Telecom Play for the Long Run

By Harsh Chauhan - July 23, 2012 | Tickers: ALU, ERIC, XLNX | 0 Comments

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There’s a domino effect around us. The impending crisis in Europe, sluggish growth in emerging markets and fears of a global economic slowdown have affected various end-markets and led to constrained spending by companies. The telecom industry hasn’t escaped this gridlock either.

Equipment makers’ nightmare

Telecom companies have kept their spending low as they try to tide over the current macro environment and negotiate slowing growth in emerging regions. This, in turn, has affected telecom infrastructure providers such as Alcatel-Lucent (NYSE: ALU), ZTE and Ericsson (NASDAQ: ERIC). Alcatel-Lucent recently said that it would miss targets in the in the second quarter owing to a “the difficult macroeconomic environment.” This news led investors to punish the stock harshly, and it declined a massive 20%. But Alcatel-Lucent wasn’t alone in its tough times.

Ericsson’s profit plummeted a massive 64% in its latest reported quarter, and the culprit – none other than weak demand due to low spending by telcos. The company experienced soft sales in three important markets of Russia, India and China and saw its margins slaughtered.

And then there was some more bad news out of China. ZTE said that it expects a massive decline in profits this quarter and cited various reasons. But as blogger Lee Samaha rightly pointed out in his post, low telecom spending in the Middle Kingdom is the real reason behind ZTE’s predicament. The result - the stock plunged a whopping 16% after the update.

Moving down

However, the buck doesn’t stop here. Companies that supply components to these infrastructure providers have also been in the doldrums, the latest among them being programmable chips supplier Xilinx (NASDAQ: XLNX).

Xilinx’s revenue pie chart is occupied mostly by ZTE and the world’s largest telecom equipment company, Ericsson. And the last few days have been anything but great for both.

With such negativity surrounding Xilinx’s two key clients, there wasn’t much that the company could have done beside issuing a weak forecast. Although Xilinx beat estimates in the first quarter with some ease, and saw a sequential improvement in its top line, its outlook didn’t inspire much confidence. The company says that it might witness irregular buying by customers in the midst of economic uncertainty, and this didn’t help.

But fundamentals are strong

But, even in the midst of industry weakness, Xilinx is managing itself well. The company is managing its costs well and keeping its margins intact. In fact, its gross margin grew to 66% in the recently reported quarter from 64% last year. Also, Xilinx is quite busy on the innovation front. Its R&D spending grew by 15% in the quarter and it released some cutting edge products. These new products are bearing fruit for Xilinx and their sales jumped 30% in the quarter.

The company also recorded double-digit growth in most of its secondary markets, which in turn drove revenue. Hence, we see that Xilinx’s diversified portfolio of offerings and presence across various markets helped it to keep the ship steady in turbulent times.

Telecom will be back

But, the most pertinent question at this point of time is, for how long? For how long will telecom companies keep a tab on their spending? It surely can’t be for eternity. Telecom companies will eventually build more infrastructures. They would need to since data usage is going to spike in the coming years. With the advent of data-hungry LTE devices, the need for more speed and the ongoing rollout of 3G/4G networks around the world, telecom spending is bound to return. The number of mobile subscribers is poised to hit the 9 billion mark in the coming five years, and most of them would be using a data connection without a doubt.

And when telecom spending does come back, Xilinx would again see better days since it counts the best of the equipment providers on its book. This brings us to the next question – when? When would we see spending by telecom players go northwards again?

If we are to believe the experts at Gartner, then it’s not going to happen anytime soon. The research firm expects that telecom spending will reach $377 billion this year, an increase of 10.8% from last year. Growth in 2011 was 17.5% and going forward, Gartner expects spending to grow 8.3% in 2013. Although we are seeing growth, it’s slowing down. But spending is still there and again, the report goes just one year forward.

Keep an eye on Xilinx

But, if you are looking at a stock like Xilinx, you would need to be in it for the long haul. As I said, we would ultimately see telecom spending rebound since we would need more networks going forward. So, in case you do have Xilinx in your portfolio, there’s no need to panic at all. And if you don’t have it, you might take a look at the stock if your investment horizon is long enough. A decent dividend yield of 2.8%, improving margins, stability, and the possibility of long-term returns is what Xilinx is capable of bringing to your portfolio.

In case you are still apprehensive about Xilinx, add it to your Watchlist by clicking here and keep an eye on how it overcomes a poor economic cycle.

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