|  By
Goli Ameri
Michael
Porter, the marketing guru, once said: “As an industry matures,
the strategic sloppiness of its constituents is eventually revealed.”
This powerful phrase pretty much summarizes the demise of the telecom
market, especially in light of the recent fraud and bankruptcy announcements
from such companies as WorldCom and Global Crossing and the massive
layoffs of companies such as Nortel and Lucent. As much as it might
feel good to play the blame game, however, there have been other
outside factors which contributed to the telecom crash including
regulatory issues, the overabundance of the capital markets and
the over-forecasted demand for Internet services.
Regulatory Issues
The Telecom Act of 1996 deregulated the telecom market and allowed
for competition in the last mile leading to aggressive network expansion
by a variety of service providers. The problem however was that
the Act did not go far enough to implement real workable regulations.
It did not mandate structural separation of RBOCs (Regional Bell
Operating Companies) in the local service market, between infrastructure
(wholesale) provider and service (retail) provider. Local rates
were also artificially low and the resale pricing program which
was implemented did not allow either the RBOCs or the CLECs (Competitive
Local Exchange Carriers) to reap adequate returns.
To meet universal service requirements, our local service has always
been subsidized mainly by long distance charges. Following the Bell
breakup of 1984, long-distance subsidies of local rates, were replaced
by temporary long-distance access charges, but the basic local rate
structure was never adjusted to reflect the real cost of local service.
This is a very politically sensitive issue.
CLECs received a resale discount on the inflated price of local
service, but they maintained that they would not be able to build
viable businesses by using the RBOC’s infrastructure high
network costs. Incumbents claimed that low resale prices would not
allow them to recover their investments and would create disincentives
to invest in advanced network infrastructure. The final result was
that the thin resale margins forced CLECs to build their own infrastructures,
creating capital requirements and long development cycles that investors
could not continue to support.
Since Universal Service subsidies will never go away and the lawmakers
will always be unwilling to increase the cost of local service,
there is no doubt that for a truly competitive local market over
the long term, alternative new last-mile technologies such as fixed
wireless will have to mature and prove their economic viability.
Service Providers: CLECs
The snafus in the regulatory environment however, does not mean
that the new competitive local exchange carriers (CLECs) bore no
responsibility for their own demise. To paraphrase Porter once again,
as the telecom industry matured, the strategic sloppiness of the
CLEC constituency was eventually revealed.
Despite the anemic resale margins, the Telecom Act nevertheless
gave a huge advantage to the competitive operators in that it did
not place undue regulatory hurdles and allowed them to choose to
extend services only to profitable regions.
Even with this important trump card, the CLECs nevertheless managed
to mess up their chances with some very egregious mistakes. For
one, many based their customer pricing not on the actual cost of
delivering the service but subsidized by receiving “reciprocal
compensation” from the RBOCs. “Recip comp” are
the fees the RBOCs were supposed to pay to CLECs for all calls made
to ISPs through their networks. As laws regarding recip comp changed
and more ISPs went out of business, this lucrative source of revenue
dried up and dragged down those CLECs who were using it for at times
up to 70% of their revenues.
Second, the CLECs were a greedy bunch and were more interested in
being acquired than to be able to provide competitive services to
customers. The acquisition game involved expanding the network and
the infrastructure to the top 30-50 U.S. markets in order to make
the CLEC sufficiently attractive to either a long distance company
looking to enter the local market or an RBOC looking to acquire
infrastructure and small business users in new markets. Teligent,
for example, the now bankrupt fixed wireless CLEC had a well-publicized
plan for such a take-over.
National infrastructure expansion and fiber deployment obviously
translated into a very high-burn rate. CLECs expanded too quickly
and overextended their resources without ever worrying about revenues.
According to one of the reputable investment banking firms, in 1996
each dollar of capex supported $5 of revenue. In 2000 it was down
to $3 and in 01 to $2. Many CLECs ended up spending up to 80% of
their capital expenditures in markets that could potentially yield
less than 20% of their revenues. As a result, less than 20% of about
300 CLECs are currently expected to survive. Many financial analysts
believe that with high expenditures in local network infrastructure,
operations support systems, and sales and marketing organizations,
a CLEC cannot survive and turn a profit unless it operates with
$1-$2 billion in revenues. There are only a handful of those companies
around.
VCs & Equity Firms
So what was the driving force behind the CLECs, national expansion?
For certain the era of greed cannot only be blamed on the new entrants;
the venture capitalists and the private equity firms are even more
to blame. These companies had access to a tremendous amount of capital,
which they invested fearlessly in the CLECs, AND drove them to a
national expansion in order to make them a more attractive acquisition
or IPO candidate. The mantra was “Don’t worry about
demand, but worry about supply, because once you build it the customers
will come”. In addition, many VC and especially equity firms
like Hicks Muse had no expertise in Telecom, yet attempted to apply
their experience with food processing or cigarette company leveraged
buyouts to the telecom world.
Vendors
The VCs of course are only one piece of this puzzle. The network
equipment vendors are just as responsible for fanning the fires
of brainless expansion. Vendors like Lucent, Nortel, ADC, Cisco
amongst others offered large financing packages to service providers
with few customers. Today, they face significant losses partially
from the credit they extended to the CLECs in the past five years.
The vendors however are not only suffering because of credit extensions.
Their own expansion to meet demand has forced them to trim their
corporate fat accumulated over the past five years. Many vendors
gambled on risky growth by acquisition, acquiring startups and their
competition, backed by the inflated price of their own stocks. Many
believe the vendors were doing what they had to do to stay on top
of the market, and they overpaid for companies since they had more
money than they knew what to do with. This acquisition frenzy has
now led to massive layoffs in addition to substantial balance sheet
write-offs, especially of goodwill. In mid 2001, JDS Uniphase for
example, posted a loss of $50.6 billion, which included $44.8 billion
in goodwill. Nortel Networks wrote off $12.3 billion in goodwill
as a one-time charge against $34 billion in acquisitions.
Due to the current capped network expansions, equipment vendors
are finding it harder to sell new inventory and the 20-30% four-year
growth after 1996, has now dropped to a negative 20% which is unprecedented
in telecom history. We do, however, have to recognize the fact that
telecom has historically had a 10% growth rate and 20-30% growth
was unprecedented itself. Additionally, vendors have to compete
with used and cheap inventories from defunct CLECs at prices ranging
from 10-50% of the original purchase price.
Service Providers: ILECs & IXCs
Up to now we have only focused on the new service provider entrants
in the telecom market, whereas the incumbent carriers, especially
the long distance service providers are equally deserving of blame.
Of course, by now we all know about the criminality of WorldCom,
where the books were cooked to show approximately $3.85 billion
of capital expenditures in lieu of regular operating expenses. (This
figure was tentatively raised to $6 billion by publication date).
The short explanation is that the $3.85 billion was mostly for local
interconnection fees which should have been booked as operating
expenditures and deducted from revenue. Booking these fees as capex
allowed the company to amortize the cost over several years, count
the un-depreciated amount as an asset and show higher profits in
2001 and early 2002.
Of course, there is no question that long distance companies have
been suffering from dwindling revenues in the past few years. Part
of this has to do with their own predatory competitive practices,
but a large part is due to the advent of IP-based telephony and
even email. Companies such as AT&T, WorldCom, and Sprint have
been looking for ways to make up for their dwindling revenues by
entering new markets. At times however, they have been amazingly
sloppy with their strategies and in turn impacting the rest of the
telecom world as well.
AT&T has been piling up debt (up to $48 billion!!), mainly due
to its cable company acquisitions which it finally decided to sell
to Comcast for $53 billion. (Even after this deal closes, AT&T
will still be $21.8 billion in debt). Pulling out this amount of
money out of the capital markets, meant there was less money for
other more savvy companies, not to mention the fact that servicing
this amount of debt has proven to be difficult for the company and
may even force it to scale back its business. In addition, since
the 1984 breakup, AT&T has lost its 90% long distance market
share to 40%, and the company was forced to further break up into
three separate entities of broadband, business and long distance.
Of course, the long distance carriers are not the only sloppy operators.
Even the venerable RBOCs have been making mistakes, but blaming
it first on the government and then the rest of the industry. The
RBOCs have also lost market share and revenues for some very simple
reasons the most important of which is the absence of communications
between their wireline, wireless, and broadband divisions.
RBOCs have lost revenues to wireless operators (including their
own divisions), since consumers have opted for inexpensive regional
and off-peak wireless service instead of second or third lines.
RBOCs have taken an inordinately long time to ramp up their services
on DSL and have therefore lost to the cable companies. Despite all
the trillions of dollars spent in the telecom world in the past
six years, the U.S. still has one of the lowest penetrations of
broadband in relation to its technological stature.
Exaggerated Demand
Last but by no means least in the litany of factors contributing
to the demise of the telecom markets was the exaggerated perceived
demand for Internet services. Internet growth was expected to be
limitless and for a while it probably appeared that way when annual
growth was at 300%. Growth however dropped to below 100% after the
initial euphoria and McKinsey & Co expects it to be around 60%
through 2005.
This sense of exaggerated demand led to not only network expansion,
but also an overcapacity in deploying long-haul fiber lines, most
of which have yet to be lit. The irony of the situation is that
despite the millions of fiber lines criss-crossing the country,
untapped demand in the local loop still has to be met!
Where is the Telecom Market Today?
The two most significant derivatives of the demise of the telecom
industry have been staggering unemployment figures and reduced capital
availability. Through the first nine months of 2001, the telecom
industry had laid off 225,231 employees including 16,000 by JDS
Uniphase, 8500 by Cisco, 12,000 by Corning and a combined 90,000
by Lucent and Nortel.
The dearth of capital is a well-known fact in the telecom world
with a $2 trillion loss in market capitalization and $600 billion
in restructured debt. What may not be as equally well known is the
eventual impact of the absence of capital on the introduction of
new technologies and services. Not only are startup companies in
the telecom space having a difficult time raising funds, but equally
as important, established vendors are no longer interested in investing
in new technologies with little immediate gain.
How to Prosper in These Changing Times?
So what are telecom companies, both vendors and service providers
to do in these trying times? The fact remains that until some of
the struggling companies beat quarterly estimates and a surge occurs
in carrier spending, confidence in the sector will remain weak.
In the meantime, companies must continue to cut costs and improve
operations. Some savvy vendors are focusing on some other crucial
factors including core competencies, exiting non-essential businesses
and targeting the top 30-50 carriers worldwide. Even Cisco has newfound
religion and despite its successes in the enterprise market, has
decided to give its service provider line of business a new venerated
stature. Tellabs, which bought next-generation switch vendor Salix
in 1999 for $300 million in stock, abandoned the softswitch market
due to lack of customer interest, a.k.a. no immediate rewards.
Telecom companies are also shedding their debt loads and are modifying
their business plans to focus on three or four lines of business.
Nortel for example has plans to focus on the optical long haul,
wireless and metro equipment markets. Lucent sold its corporate
golf course, the Hamilton Farm Golf Club in New Jersey, for $40
million. Expect to see further mergers and consolidations to allow
for smaller vendors to present their state-of-the-art technologies
to money spending service providers. The trend has already started
with Ciena making a small investment in multi-service switch vendor
Equipe Communications.
Service providers on the other hand are focusing on the customer.
Both wireline and wireless carriers have finally understood that
it takes 5-30 times more to acquire a customer than to retain one,
yet in the past they had allocated a disproportionate amount of
resources to chasing customers. Renewed interest in customers means
that there will be incremental expenditures in OSS (Operations Support
Systems) and CRM (Customer Relationship Management) systems.
Emerging service providers have learned to scale back national expansions
and focus on regional gains and controlled growth. They are loading
up on existing networks and aspiring to have a critical mass with
existing customers. There is also a renewed interest in traditional
metrics like positive EBITDA (Earnings Before Interest, Tax, Depreciation
and Amortization) -- in the first year -- and demonstrating a clear
route to profitability. There will also be further consolidations
in the long-haul space as evidenced by Level 3’s attempted
take-over of Williams Communications.
Future Is Bright
The telecom market will get back on track and once the issue with
WorldCom is properly resolved, we should expect to see increased
spending in mid 2003. (In his keynote speech to the ITF2002 Conference,
Krish Prabhu with Morgenthaler Ventures said that the recovery window
might shift a year to end of 2004 or early 2005 because of the current
fraud and bankruptcy-related cases.) The U.S. telecom market is
a very strong industry with combined local and long distance revenues
of $285 billion in 2000 and expected to reach $422 billion by 2005.
The local telecom market provides $120 billion of revenue, 45% EBITDA
margins and 5% growth rate. The drop in spending was originally
forecasted at 15-35%, but in reality according to Robertson Stephens
it has been 13% in 01, 12% in 2002 and expected to be 6% in 2003.
RBOCs are also continuing to spend money on building out and expanding
networks, and are expected to spend the same percentage on capital
expenses as they had in the 1990 to 1995 range and the 1996 to 2000
range. The Bush economic stimulus package will also help future
capex expansion.
According to the U.S. Telecom Association, in 1996, when the Telecom
Act was passed, competitive carriers controlled about one million
access lines. Today, CLECs control about 20 million lines, which
represents a market share of about 10%. BellSouth just released
the results of a study that says the RBOCs now account for only
60% of last-mile customer connections when all types including wireless
and voice over IP are considered. These figures, especially BellSouth’s
study indicate great progress and great hope for the future.
The news is even better on a worldwide scale. Traditional telephone
lines have more than doubled to 983.3 million from 407.9 million
worldwide between 1985 and 2000. The rate of deployment has increased
from 4.9 percent to 7.3 percent a year and is expected to continue
to do so, helped by strong demand in China and India. Wireless subscribers
have increased by 242 million worldwide in 2000, and 246 million
in 2001, and are expected to continue to increase by at least 100
million each year through at least 2006.
The expected growth in the telecom market will translate into opportunities
for both vendors and service providers. There will be some kind
of regulatory relief between the diverging opinions of Senator Hollings,
who believes the federal government should mandate the structural
separation of the RBOCs, and Congressman Tauzin who believes that
the best way to rectify the Telecom Act is to allow RBOCs into data
long distance without first securing Section 271 approval from the
FCC. Both of these regulatory initiatives will further stimulate
capital expenditures.
The infrastructure of failed companies will continue to provide
an opportunity for other companies to gain vital network assets
at considerably cheaper prices. Dave Dorman, the President of AT&T,
announced as recently as late July that “AT&T continues
to examine bankrupt assets as a substitute for new capital deployment.”
Vendors with solid products will continue to see demand, because
although budgets have been cut, customer demand has remained constant.
Companies will have more realistic business plans and the next wave
of prosperity will be more solid, based on actual results and rational
projections. Killer technologies with strong demand will be in the
metro optical, optical switches, voice over packet equipment and
wireless infrastructure and will generate their own demand. Alternative
last mile technologies (like fixed wireless) will eventually mature
and prove their economic viability.
The telecom downturn has actually had a Darwinian effect, where
the incompetents have disappeared and there will be increased funding
for the stronger companies.
Goli Ameri is the President
of eTinium, Inc. (www.etinium.net) a Telecom Consulting and Market
Research Company specializing in wireless and switching technologies.
She can be reached at gameri@etinium.net.
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