Has slump hit bottom?

WASHINGTON, D.C. - The network industry got mixed economic news last week. A survey showed venture capital spending has come out of its nosedive, but Senate leaders shelved a proposed tax break that could have boosted corporate IT spending.

The venture funding news and other positive developments prompted experts to conclude the 18-month industry slide has likely hit rock bottom. However, they remain cautious about how quickly the industry will rebound.

"We're seeing a glimmer of hope,'' says Harris Miller, president of the Information Technology Association of America (ITAA), a lobbying group with 500 members, including IBM, Microsoft and Novell. "It's going to be a tough year, but various indicators that I tend to look to and trust . . . have bottomed out. So that's good news.''

"It's going to be a slow recovery,'' says Bill Collatos, managing general partner at Spectrum Equity Investors, which specializes in communications start-ups. "I think the worst is over. The shakeouts and [low] valuations have happened. There are still companies that are lingering that won't make it, but they'll get flushed through this year. I think some cautious bets should be made this year.''

The latest venture capital data indicates that investments in network start-ups are settling at $4 billion per quarter. This comes amid other promising economic news, including a drop in the unemployment rate and an increase in manufacturing activity during January. Many economists predict an overall recovery will begin soon.

Analysts say the network industry's recovery depends on how quickly and to what extent chief executives loosen their grip on IT budgets and let network executives upgrade hardware, add bandwidth and roll out applications. One possible sign of that trend starting was last week's announcement of higher-than-expected earnings by network bellwether Cisco, although its stock price dropped anyway amid continued investor jitters.

Gartner foresees few major changes to corporate networks in 2002.The consultancy says network executives will continue to invest in technology that improves productivity, reduces costs and has a quick return. Among the likely investments are security, storage and Web-based applications.

"Most companies are not looking at doing anything internally unless there's a 20% return on investment in the first year,'' says Dave Neil, a vice president at Gartner. "If that is the situation, then companies are willing to spend money on new applications or infrastructure.''

Neil says one of the exceptions to this rule is network security. "Companies will continue to invest where there's a threat to the enterprise...but these are not going to be multimillion dollar purchases,'' he adds.

With the macroeconomic news improving, network executives seem ready to make modest investments in infrastructure and applications.

Carlson Hospitality Worldwide is encouraging owners of its 700-plus Regent, Radisson and Country Inns and Suites hotels to upgrade internal data network links and upgrade to high-speed Internet access for guests.

"We are in the process of doing a complete broadband data network upgrade to our Radisson and Country Inn brands,'' says Jim Grimshaw, director of hotel systems. "Some of our smaller properties and [ones in] tertiary cities on slower dial-up lines are now going to fractional T-1s, DSL and ISDN-type connections. We're going to a minimum standard of 128 kilobits [per second].''

Grimshaw says Carlson's hotels increasingly use centralized applications, the Internet and e-mail, which is driving the need for a more powerful data network.

"The little capital expenditures that are required will be well returned over time,'' he says.

The Senate's decision to end its debate on economic stimulus legislation was a blow to corporate IT buying plans such as Carlson's. Despite President Bush's appeal in his recent State of the Union address, Senate Democrats and Republicans couldn't agree on a bill designed to improve the economy through a combination of tax cuts and unemployment assistance.

Proponents of an economic stimulus package supported changes to the tax code that would have let companies depreciate investments in network hardware and software at a faster rate than is allowed currently. The tax code changes would have applied to purchases made after Sept. 11. Proposals differed on how much extra depreciation would be allowed and for how many years.

By accelerating the depreciation of network gear, lawmakers would have given corporate IT buyers a discount on their purchases. Industry observers say these tax code changes would better reflect the modern business environment, where high-tech equipment quickly becomes obsolete after purchase.

The death of the economic stimulus package is "very unfortunate,'' ITAA's Miller says. "It would clearly have accelerated spending on hardware, telecom and Internet-related software because now the depreciation schedule in the tax code is way out of line with the useful life of these products. CFOs who are unsure about spending money on updating routers or software would have been tipped toward that direction if they were told the product was essentially on sale.''

Such tax breaks would "certainly influence the next decisions we need to make in terms of how quickly we scale up our data network infrastructure,'' Carlson's Grimshaw says.

On a more positive note, venture capital invested in start-ups appears to have stabilized. A key indicator of the health of the network industry, the amount of these investments leveled off at $4 billion during the fourth quarter of 2001. While that figure is off 73% from the high-water mark of the Internet boom, it's still roughly double the amount invested before that bubble. These figures are from a special analysis of quarterly venture capital data compiled for Network World by PricewaterhouseCoopers, the National Venture Capital Association and Venture Economics.

According to the MoneyTree Venture Capital Survey, more than 460 network start-ups received an average of $8.75 million last fall. Sixty network start-ups closed deals worth $20 million or more. Among the hot areas for investment were enterprise-class software, security and Internet infrastructure.

The latest venture capital figures follow five quarters of steep declines. Investments peaked in the second quarter of 2000, when $14.7 billion was poured into 939 network start-ups. The amount invested and the number of deals dropped steadily until the third and fourth quarters of 2001, when $4 billion was invested in each quarter.

"Venture investments are showing good signs of recovery,'' says Tracy Lefteroff, global managing partner for the venture capital practice at PricewaterhouseCoopers."Despite the tough economy and the events of Sept. 11, we see activity across the board in venture funds, and we hear that the climate is improving. We think we have bottomed out and are clearly on the road to recovery.''

The survey reports total investment in network start-ups during 2001 surpassed $20.8 billion. This compares with $53.5 billion in 2000 and $22.9 billion in 1999. Moreover, last year was the third-best year for venture capital investments in the network industry.

"We're still more than double what we saw in 1998 and well above historical norms,'' Lefteroff says. He adds that "the level of activity in the first quarter [of 2002] so far is very encouraging.''

Among the largest deals of the quarter was $62 million invested in Cogent Communications, which provides high-speed Internet access to multitenant buildings. Cogent CEO Dave Schaeffer says the company's roster 4,000 corporate customers was a factor attracting venture funding and an additional $99 million in debt financing last quarter.

"We see extremely strong demand because of the radical pricing we bring to the market,'' Schaeffer says.

Cogent offers 100M bit/sec Internet service for $1,000 per month. This service is about 65 times the bandwidth of a T-1 line, which costs about $1,400 per month.

"Because our service is an [upgrade] in terms of quality and reliability, and it's less expensive, we think we're going to have a very good year,' Schaeffer says. "But the market in general will continue to be a tough one.''

Despite their cautious outlook for this year, experts remain bullish on the long-term prospects of the network industry.

Mark Heesen, president of the National Venture Capital Association, predicts that the level of investment this year won't match the record-breaking year of 2000. "But those were unrealistic levels. We do see some conservative growth throughout this year, and that's very good news.''

Spectrum Equity's Collatos has noticed modest increases in follow-on investments for existing portfolio companies and new, early-stage investments. However, he says most of the investment is geared toward evolutionary rather than revolutionary network technologies. He blames the collapse of the competitive local exchange carrier market for this shift.

"I see evolutionary changes, from 10G [bit/sec] to 40G bit/sec, in the circuit infrastructure. I see increasing voice traffic in the IP environment. But the revolutionary stuff - the construction of the last-mile broadband to the home . . . and the transition from traditional electrical to optical switches - will not happen this year,'' Collatos says. "That's going to take a long time.''