The End of Telecom As We Know It and I Feel Fine

by: Andrew Schmitt

I feel like I am turning up good scenarios where companies are tactically or structurally overvalued. I feel like I’ve found good value plays in the tech sector, particularly if my consolidation models work out. I can even reconcile the valuations of big companies like Microsoft (NASDAQ:MSFT), Broadcom (BRCM), and Intel (NASDAQ:INTC) based on the enormous opportunities that exist as more sectors of the economy and more segments of our lives transition from analog to digital.

But at the end of the day, there seems to be a lack of home-run ideas in Telecom infrastructure. I challenge anyone here to name a publicly traded Telecom component or equipment company that will be worth 10x what it is today in five years based on fundamental growth. Another way to look at it - name a public company that will increase revenues by 10x without eroding margins.

It was not always this hard. Where do the big 10x opportunities exist in the telecom & communications sector today? Nothing jumps out, at least to me.

I think it is pretty clear the whole industry is ripe for some major disruption. Rather than be pessimistic, it’s time to be optimistic, and identify what trends could reverse the industries fortunes.

Let’s look at the key ingredients for stratospheric growth:

1. Relatively small market cap today. It’s a lot easier to grow from $1BB to $10BB than it is to go from $10BB to $100B. So throw out many of your household component and equipment names.

2. Defensible concept. Optical module makers like Finisar (NASDAQ:FNSR) and Avanex (AVNX) may be big and vertically integrated but as of today there are few barriers to entry. Toss out most of the component vendors.

3. Fat margins. Usually the result of #2. Intel, Broadcom, Cisco (NASDAQ:CSCO) are good examples.

4. Sticky. Once embedded, can’t be cleansed. Microsoft Windows. Your home phone number. The first email address you used widely. It’s hard to throw out a Broadcom Ethernet switch because the software investment, not the silicon itself.

Yeah, yeah, I know it’s a Five Forces ripoff.

It is exceptionally hard to identify existing communication infrastructure companies that meet these criteria. Many opportunities exist for 2-3x valuation based on consolidation. But where is the home run based on growth, and not decomposition? A critical look at the criteria above bring to mind a software company, not a hardware company.

It is increasingly clear to me that the growth opportunity in Telecom is going to be on the software side, not the hardware side.

Much like sexy big-iron computing hardware was commoditized into a common platform by Microsoft, sexy big-iron Telecom will follow the same path. The worst offenders appear to be specialty hardware boxes for specific applications, like Video Servers, Core Routers, or softswitches. Why not buy a few racks of bladeservers that can do all of the above?

When I think of Telecom companies today, just like analysts in 1980 thought of computers, I think of tricked out hardware. But there appears to be much more upside in turning communications equipment in a commodity and moving the value into software.

People think of Cisco as a hardware company. Take away 25% of Cisco’s operating income from marking up optical modules, and look at where the value really is. It’s IOS, the software that welds together all of their systems. The hardware exists only to monetize that software monopoly. Maybe they should just sell the software and let Huawei/3Com (COMS), HP (NYSE:HPQ), and Dell (NASDAQ:DELL) kill each other building the hardware.

Today, I can name 5 communication hardware companies for every software company. In 10 years, I expect this will invert. I intend to start focusing more of my time to understanding this transition.

Inspired by Martin Geddes' excellent post "IMS is just an application".

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