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Light at end of telecom tunnel?

The worst may be over--or will be over soon--for the battered telecommunications sector, according to a Wall Street research analyst.

The worst may be over--or will be over soon--for the battered telecommunications sector, according to a Wall Street research analyst.

Sanford Bernstein analyst Paul Sagawa says equipment spending by telecom carriers will fall this year and next year overall, but will also rebound slightly at the end of 2002. Sagawa, viewed as one of the more astute number crunchers on Wall Street, does not own stocks in the markets he researches.

Sagawa predicts that equipment spending by telecom carriers in 2001 will fall 16 percent to $102 billion, from $121 billion in 2000. Carrier spending will then slide again by 21 percent to $80 billion in 2002 from the previous year.

This plunge is in stark contrast to spending in 1999 and 2000, which grew 32 percent and 40 percent, respectively, from previous years, according to Sagawa.

But there is some good news, as a bottom appears to be in sight. Sagawa predicts that spending will grow in the fourth quarter of 2002 from the same quarter in 2001.

"The kind of bloodletting that we've seen is more than sufficient to get the carriers back on track in terms of their cash flow," said Sagawa, who was one of the first analysts to predict a telecom downturn during a time when telecom spending and stock valuations were shooting through the roof.

He points out that spending has dropped each quarter for some time and will keep falling, quarter to quarter, through the second quarter of 2002. Yet he also believes that the slide can only go so far before carriers pick themselves up and spend again to update their technology.

He cautiously advises in his report to investors to buy shares of old-school telecom companies like Nortel Networks and Lucent Technologies, which have fallen to attractive price levels.

"While we remain cautious, given near-term sales declines, we recommend taking advantage of market weakness to increase exposure to traditional telecom equipment franchises with significant bottom-line leverage," Sagawa wrote in his report.

He thinks that telecom carriers already use a lot of equipment from Nortel and Lucent and will therefore buy spare parts and upgrades from them rather than try systems from newer equipment makers.

Sagawa also believes that Cisco shares are too highly valued compared with Lucent's and Nortel's, which he puts at about 0.75 and 0.8 times sales in 2001, respectively.

"Cisco's valuation remains relatively robust at 5.75 times sales," he said in an interview. "They are not close to being a six-times better company."

While many Wall Street analysts believe carriers will spend less before spending more, there is disagreement over exactly when spending will grow again.

"I am hopeful about late '02, but only hopeful, because there are so many moving parts," said analyst Steve Kamman at CIBC World Markets, who believes investors should remain cautious.

"Probably the more important thing for people to recognize over the next year is that there is going to be more selective spending," he said.

Like Sagawa, Kamman thinks carriers will refrain from spending except in areas where they have no choice.

Carriers will shy away from new kinds of equipment and focus on maintaining older equipment, similar to the way consumers during hard economic times elect to repair old cars and drive them into the ground rather than splurging for new vehicles.

Carriers also have little choice when it comes to adding capacity to meet demand. If more customers are using their networks than before, phone companies must buy more equipment to handle the increased usage.

If demand snowballs and forms a critical mass, spending might grow more quickly. Kamman thinks a lot depends on consumers and how fast they move from relatively slow dial-up Internet connections to speedy broadband access.

Kamman doubts corporate America will lead the surge in demand. Though businesses use broadband heavily, they also have adopted high-speed access faster, leaving less room to grow.

"The only number to watch over the next year is the broadband penetration number," said Kamman, who says that only about 8 percent of consumers have high-speed access and thinks that must increase to between 15 percent and 20 percent to significantly stoke demand enough to get carriers spending again.