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Telecoms anticipate price cuts for gear

Telecommunications carriers are driving a hard bargain while shopping for networking equipment--and some networking companies are giving in with steeper-than-usual discounts.

Telecommunications carriers are driving a hard bargain while shopping for networking equipment--and some networking companies are giving in with steeper-than-usual discounts, analysts and executives say.

In fact, Joseph Nacchio, chief executive of communications carrier Qwest Communications International, says he's demanding that networking companies play "Let's make a deal."

"We've been able to take advantage of an extraordinarily favorable pricing environment from our suppliers who are scrambling for every dollar they can get," Nacchio said in a recent conference call with analysts. "We're just pressing vendors across the board--whether it's optics, DSL, adding switched ports or software releases. It's become a buyer's market and we're taking advantage."

Some networking companies, ravaged by the sluggish economy and slower spending by carriers and service providers, have begun cutting prices to spur their customers to spend money again, analysts say. It's difficult to gauge the size and scope of the price cutting, but anecdotal evidence indicates that it is happening and goes beyond the normal price erosion that is common in the tech industry.

Although it's not certain there will be an all-out price war, some skirmishes are breaking out, which could prove to be a harbinger of future battles, analysts say.

"You are seeing systematic slashing of prices by equipment companies," said Lehman Brothers analyst Steven Levy. "From 1996 to 2000, the equipment vendors were growing faster than they ever thought they would grow. The carriers were spending more than they thought they would--and it was the equipment companies that had the upper hand.

"Now that it's a declining market, the biggest companies are desperate for revenue and the carriers know that," Levy added. "So you see companies like Qwest going to existing contracts and renegotiating. They smell blood."

Even though some analysts see price cutting, some say the discounting is moderate, depending on the product. Prices for higher-end products should hold up better, while lower-end technology faces steeper cuts, they say.

"I don't yet see companies cutting prices on products that have a technology advantage," said David Spreng, managing general partner of Crescendo Ventures, a venture capital firm specializing in communications.

Cisco Systems, Juniper Networks and Extreme Networks say they are not cutting prices on their products, outside of the usual discounts they give customers who buy products in bulk. Lucent Technologies executives declined to comment.

Even emerging service providers XO Communications and Yipes Communications say they have not seen better deals. Other large carriers declined to comment on their relationships with their network equipment suppliers.

Margins fall
But larger networking companies, such as Cisco and Nortel Networks, have seen a decline in their gross margins, or the difference between their sales and cost of sales as expressed in percentage terms.

Cisco's gross margins fell to about 54.5 percent in the March quarter from 61.8 percent in the previous quarter. Nortel's dropped to about 30 percent from 45.5 percent over the same period, showing that the companies are making less money on every sales dollar.

Additionally, networking companies Ciena and Foundry Networks, as well as Telseon, an emerging service provider, say price cuts are happening. In the company's quarterly earnings conference call with analysts last week, Ciena executives said they have encountered aggressive pricing from its rivals in optical networking equipment.

Executives at Foundry, which competes against Cisco and others for service provider and business customers, say they have become more "flexible" with the pricing of some of the company's lower-end products.

"Every company is going to try much harder to listen to their customers, and if the other guys are more aggressive, you have to respond," said Ken Cheng, Foundry's vice president of marketing. "We don't engage in price wars. We are not going to give away the store to win a deal. But the bottom line is you have to show flexibility. We are typically more flexible with the more commodity-type products."

John Kane, CEO of Telseon--a communications service provider that buys equipment from Extreme, Foundry, Riverstone Networks and ONI Systems--says the downturn has caused equipment makers to cut prices in the past six months.

Two to four years ago, sales representatives for networking hardware companies would offer carriers a printed brochure, a price list, and a date when they could deliver the equipment. Now they're more willing to deal, Kane said.

"The new guys come to see you with a blank sheet of paper," he said. "At trade shows, they'd say, 'Yeah, maybe we can take an order for you.' Now they have become more humble."

Analyst Michael Howard, of market analysis firm Infonetics Research, said he believes Cisco has begun to offer bigger-than-usual discounts to customers. That is driving other networking players to also lower their prices, he said.

"What we're hearing from the big carriers is that Cisco is being very aggressive with pricing, and that forces everyone else to be aggressive," Howard said. "It is not normal discounting."

Foundry's Cheng agreed, saying Cisco has historically charged higher prices for its products, but the networking giant has become more competitive with its prices in recent quarters.

"Cisco is more willing to do price discounts now," Cheng said. "These are certainly more desperate times for them."

A Cisco spokesman disputed Foundry's claims, describing the company's discounting as no different than previous quarters. "Cisco's prices have never been a driving factor behind networking sales--and that's also true today," the spokesman said.

As an example of how fast and steep sales have plunged, Cisco last quarter wrote off $2.25 billion in excess inventory, mostly raw materials and components that the company uses to build networking products.

Not just any sale
The practice of cutting prices to persuade timid customers to buy in times of uncertainty is not new. In the technology industry, especially, prices for products ranging from personal computers to semiconductors to software routinely fall over time. But nudging service providers to invest millions in equipment is more complex than urging consumers to buy socks on sale.

"There's a lot of capacity out there, and the carriers don't have the money to spend," said Paul Sagawa, an analyst at investment banking firm Sanford C. Bernstein, who notes that telecommunications service companies have already spent significant amounts in the recent past and seem to prefer to catch their breath.

Wall Street analysts have predicted that the slowdown in carrier spending this year may bleed into next year and future years, but the carriers are still going to spend billions of dollars on equipment every year. To get carriers to open their wallets, price cuts are a powerful tool to defend a company's share of the market against competitors.

Tad LaFountain, an analyst at Needham & Co., an investment bank, believes the networking companies gave themselves some breathing room when they significantly cut their earnings outlook for the year, which reduced the pressure to beat lofty profit projections.

Most analysts think that some strategic price reductions will be the extent of the price cuts, instead of large-scale discounts.

Selling equipment is also very different from selling commodity items such as processors or PCs, said Gartner Dataquest analyst Tim Smith. Carriers see telecom equipment as highly specialized gear that is not easily interchangeable like an AMD or Intel processor, so companies can play the advantages of different features to attract customers instead of just offering discounts.

But while most analysts believe price cuts are occurring only in low-end products, Epoch Partners analyst Ashwin Navin believes sparks could fly between Cisco and Juniper in the high-end market for Internet routers, devices that service providers use to speed data traffic through the Net.

Juniper continued to swipe more market share from Cisco in the first quarter in the high-end gear market, gaining 38 percent of the market to Cisco's 59 percent, and Navin believes Cisco will dig in and try to push Juniper back more aggressively. That might mean some heavier discounting, he said.

Cisco has historically bundled products together, such as Cisco's top-of-the-line 12000 series equipment, with some lower-end 10000 series routers thrown in at reduced prices. But that practice might accelerate, Navin said.

With such a strategy, Cisco slashes margins on lower-end gear but protects its gross margins on the high-end products where it can make the most profit. Navin says that practice is similar to automobile pricing: The more features an automaker can load into a luxury car, the higher profit it can make compared with that on a midrange vehicle with fewer bells and whistles.

But Navin speculates that competition might become so heated that Cisco might even start discounting prices on the high-end 12000 series, which would eat into the company's bottom line even further.

"It's definitely turning into a buyer's market for service provider equipment," he said.