Robbie (and thread), i guess you all saw the Salomon Smith Barney report from September 20, 2000, but i thought i'd post most of it here and hope that i don't go to jail. (i don't agree with 100% of this, but for the most part it makes sense.)
Telecommunications Services Sentiment Belies LT Industry Growth;Strongly Reiterate Bullish Stance
September 20, 2000
OPINION
We want to take this opportunity to strongly reiterate our bullish view of
the telecom services industry. We remind people that our long-term
investment thesis on this industry remains unchanged despite the fact that
the stock performance of the telecom services sector has fallen off a cliff.
First, we believe that the revenue growth in this industry over the course
of the next 5 years will actually accelerate as we shift the mix of revenue
away from circuit-switched voice towards packet-switched services, optically-
based services, and especially bandwidth-intensive services.
Second, we believe that as capital spending goes from roughly 30% of revenue
to probably 15%-20% of revenues, over the course of the next 4 or 5 years.
We believe we will start to see free cash flow generation and accelerating
return on invested capital as the new capital deployed in the current
environment drives down operating cost and enables a slew of new
applications.
Third, we have always believed in the segmentation of this industry. This is
a $1 trillion industry on a global basis, almost a $300 billion industry in
the United States - with very different sets of telecom service buyers,
ranging from consumers to SMEs to large multinationals to technology buyers
that simply buy bandwidth. Thus, there is opportunity for multiple business
plans to succeed. This is not an old vs. new, horizontal vs. vertical
debate. Rather, the skilled management teams in every segment of this
industry should be able to drive value.
The basic tenets of this industry has remained unchanged in the 25 years that
we have been associated with telecom. Technology drives down costs, which
drives down prices, which stimulates demand for existing services. Secondly,
Say's Economic Law has always been valid. Namely, expansion of supply
creates its own demand. Thus, new applications are enabled with the
prevalence of cheaper bandwidth. The most value is driven in any element of
the value chain by companies that have the most pervasive set of network
assets off of which to drive the fullest product set and hence capture the
most customers.
The telecommunications services sector has typically outgrown GDP by a factor
of 2 to 1 over the last 3 decades. We would argue that this multiplier will
increase as network-based services become the enabler for what is a web-
centric world.
STOCK PERFORMANCE HAS BEEN LACKLUSTER
Having said all of this, why is it that the stock performance of this group -
top to bottom - has been miserable? With ytd performance of this group
anywhere from down 25% to down 60% across the board, with 52-week performance
not much better.
Specifically, the incumbent players are trading at their lowest relative
P/E's in 5 years. In fact, they have lost 3 to 4 relative multiple points to
the market in the last 26 months. The emerging players are trading near
their lows. They are near their historic, albeit short (since many came
public over the last 3-4 years), lows on forward multiples on revenue and net
plant and clearly are trading at very steep discounts to DCF values, even if
one wanted to haircut DCF values going forward.
The reason we believe that the sector is under pressure and continues to be
under pressure is that we believe that other analysts are raising issues that
are not new - other than the fact that the stocks are down a lot. We thought
we would take this opportunity to address some of what we believe is
overhanging the sector. We particularly wanted to provide our commentary on
these issues.
Before we do that, we thought it would be appropriate to remind people that
from the time MCI Communications went public, in 1972, to the time it was
bought by WCOM, in 1998, MCI outperformed the S&P 500 by 8 to 1 with a
cumulative price performance of 6000% vs. 800% for the S&P 500. MCI
outperformed the NASD by 4.5 to 1, with a cumulative price performance of
6000% vs. 1300% for the NASD. During that time, MCI lost at least 50% of its
value on 9 different occasions. In particular, if you look at the period
from October 1973 to October 1989 - the last time MCI had such a downdraft -
MCI outperformed the S&P 500 by 10 to1, and the NASD by 7 to 1. This was in
a 16 year period, despite losing anywhere from 52% to 84% of its value peak
to trough, 9 separate times.
Our point is the following: Telecommunications is, and remains, a growth
industry. Telecommunications is and remains a capital-intensive industry.
Thus, companies in this industry will always go through spending periods to
develop network infrastructure, which drives products, which drive growth.
Because of the nature of the beast, there are hiccups along the way. MCI
remained, clearly, Exhibit A in both the travails and - more importantly -
the benefits of being a well-run company. It started from nothing and gained
critical mass in a growing, but capital-intensive, industry. Thus,. we
thought we would walk through a few points to hopefully put investors at ease
in terms of this group.
TECHNOLOGY & PUBLIC POLICY WILL CREATE GROWTH OPPORTUNITIES
First, there are 2 cataclysmic changes going on: technology and public
policy. Five years ago, less than 5% of the 700 million U.S. phone lines
were in markets with open competition. Today, over 90% are. Secondly, we are
going from a circuit-switched world to an optical packet-switched world.
Ultimately, everything will be characterized by bits per second (bps), as
opposed to minutes or circuits. Either of these changes would be disruptive.
Both, simultaneously, are clearly disruptive. But, at the end of the day,
the result of public policy opening up markets and the shift to optical,
packet-based bit-driven technology - the combination of these 2 things -
will dramatically expand the market for telecom services. Obviously, the
challenges for all players in this industry is to navigate through these
changes.
Open competition provides huge opportunity for new players that have to build
businesses and it provides challenges for incumbent players to diversify
assets to grow through what will be inevitable share loss. The technological
shift, we would argue, is a more subtle change. There is no question that
revenue per binary digit, for voice services, will come down as we go to an
all-packet world. However, cost also comes down. With the demand for bits
going through the roof, the long term ramification of a bps-based telecom
world is quite beneficial. There will be a transition period as legacy
revenue streams will reflect the pricing of lower-cost networks.
Thus, we would argue that technology and public policy changes are for the
good of this industry, will create huge growth opportunities, but have to be
navigated through over the course of the next couple of years.
CUSTOMERS & BREADTH OF SERVICES ARE CRITICAL FOR GROWTH
The name of the game is simple: to have the most customers and the most
services no matter what type of company you are. A company can be
vertically-integrated, horizontally-focused, SME-oriented, or a multi-
national corporate supplier. That, obviously, leads to different challenges
for old vs. new companies.
New companies have the luxury of starting from scratch, taking market share
and being able to have entirely new networks built. However, they have to be
able to build a business, not just assets. They have to finance their
business plans. They have to build infrastructure in order to compete. On
the other hand, incumbent players do not really have issues with capital.
They have a lot of customers and revenues, but are faced with loss of market
share and devaluation of legacy revenues. Thus, the incumbents have to
diversify assets and create new services to drive growth. We would argue
that the better new companies and the better old companies, the better
vertically-integrated companies and the better horizontally-focused
companies, will all - at the end of the day - drive value. It is not a zero-
sum or a mutually-exclusive gain. Thus, as we said, issues that have been
raised regarding oversupply of bandwidth, CLEC business models being viable
and financeable, return on capital are nothing new. In fact, the issues
could have been raised a year ago, when the stocks were 60% higher.
COST EFFECTIVE NETWORKS HELP DRIVE DEMAND & WEALTH CREATION
Let's quickly look at each of these issues. As far as bandwidth is
concerned, we have talked about this a million times. We will continue to
stress the same thing. The cost-effectiveness of optical networks for new
applications is a means to wealth creation in this industry.
We've heard all the chatter: five new networks crisscrossing the continent,
a flood of new fiber, excessive Pan European networks, a bandwidth glut to
last until the middle of the next decade. We emphatically beg to differ.
Number 1, fiber in the ground does not equal bandwidth in the network. Fiber
does not equal bandwidth because the incremental cost of installing as much
fiber as possible while digging up the earth is cents per fiber meter.
Therefore, while you are digging up the earth, you might as well put in as
much fiber as possible in the first installation. However, fiber in the
ground does not stay useful forever because it could be in the wrong place.
Fiber does age and get damaged over time. You may have the wrong specs and
not be able to pass high-speed signals.
Furthermore, operators tend to run their networks in a very disciplined way.
A company will not light up a fiber pair until there is visibility of 35%-40%
of utilization on that fiber pair. If a company runs a fiber pair much above
60%-65% utilization, or it will not be able to guarantee the network
integrity needed for optical carrier and high-bandwidth services. Moreover,
on terrestrial networks, the cost of lighting up fiber is roughly 8x what it
costs to build a network. That's only assuming 1/3 of the dark fiber is ever
lit. In fact, most network engineers would argue that no more than 20% of
dark fiber will ever be lit. Thus, fiber in the ground is interesting but
irrelevant. Bandwidth has everything to do with what is lit, which is
directly demand-driven and demand is growing.
Furthermore, bandwidth required is growing faster than traffic; thus; optical
networks are going to be hard-pressed to keep up with demand. If you do the
math, it's quite simple. There are more users using faster devices at the
edge of the network with more applications - whether it is streaming content,
real-time software downloading, caching, and the like. These services are
driving more time on-line, more bandwidth per device, and higher payloads
per unit of capacity.
Most forecasts for growth of just IP alone create the prospect of a network
with 30x today's traffic on the public-switched network in less than four
years. In fact, according to industry sources, total demand worldwide for
data and voice will grow from roughly 4 billion Gbps per year to almost 20
billion Gbps per year by 2005.
Additionally, in a packet network, packet traffic is engineered very
differently than voice. In a voice world, a network is engineered for
predictable peak hour usage. In the packet world, the network requires huge
excess bandwidth to function properly with bandwidth supporting peak traffic
loads. Bandwidth is needed to support retransmission, recovery and
unpredictable bursts of data. When one makes a voice call and that circuit
goes dead, the calling party hangs up and calls back. In contrast, when a
network provider is guaranteeing no packet loss on data transmission, if
there is one lost packet, it requires the retransmission of the entire
payload - not just the lost packet. The faster the transmission, i.e. the
faster the speed guaranteed, the more data that is in the glass that has to
then get re-transmitted. The solution is more bandwidth. The restoration
and recovery requires re-transmission of more than just the lost information
but the restoration and recovery cascades throughout the network, bringing
down other routers and other devices. There is a very simple solution: the
network engineer throws more bandwidth in the network to overprovision.
Furthermore, forward error correction is required to transmit extra data.
The bottom line is that as bandwidth demand increases, bandwidth required
increases more. There is no question that price per bit will decline due to
traffic mix. Clearly, voice on a per bit basis is priced much higher than
data and packet-based services. But, data bps are going to grow by a factor
of 10x while voice bps are only going to grow at 50%. Thus, the bottom line
on the bandwidth side is that as costs for putting in technology in a network
decline, which they have from $210,000 per Gbp in 1994 to $4,000 per Gbp
today, bandwidth becomes more prevalent. The decline in cost drives more
bandwidth demand and it is also important to note that dark fiber does not
equal capacity. As the bps that require more network protection and
restoration grow at many multiples of the bps that don't require such
protection: it becomes a self-perpetuating thing. The more applications that
use more bandwidth that require more sophisticated protection and restoration
means even more bandwidth is required to serve the end-user.
Thus, we believe that the notion of bandwidth glut is preposterous. We have
heard this refrain over the last two decades, and the reality is that as cost
per unit goes down, drives down prices, drives up demand, but the reality of
network engineering is that the more bandwidth demand that is required, the
more bandwidth supply is required to meet that demand within the
specifications promised. One important issue to the industry is that as we
speak, 60% of the bps are voice, whereas in 5 years, 80% of the bps will be
data. Obviously, this has ramifications on revenue per bit. However, cost
per bit is declining even faster.
WE BELIEVE THE CLEC MODEL REMAINS A VIABLE BUSINESS PLAN
The other issue that is worth addressing is the viability of the CLEC model.
The bottom line is that there are clearly too many companies out there, as
opposed to too much capital. As we have seen in the banking industry, we do
believe there will more consolidation and fewer companies within the emerging
network area - just like we have seen within the incumbent space.
In the meantime, the basic premise of the CLEC model is unchanged. The fact
is that 15% of the RBOC assets cover 70% of the RBOC business lines. Thus, a
CLEC can cover 50%-60% of RBOC cash flow by overbuilding roughly 15% of
RBOC/ILEC assets. It is clear that as the CLECs are adding a half a point to
a point per quarter of market share - representing 60%-70% of the growth in
net adds - that the CLEC business model is working. There are obviously
issues with transitory revenue streams such as recip comp and switched
access. The reality is that the better names in this space, we believe, will
build viable business models. We would argue that in the course of the next
5-10 years, the CLECs as a group could clearly capture 30%-40% share of the
local exchange business market if one could even define a market that way in
the out years.
As far as financing is concerned, the better names - MCLD, NXLK, ALGX, WCII,
FCOM - should be able to fund their businesses and build viable business
plans. In fact, the MCLD bonds are outperforming the high yield market
significantly and still trading at about a 10% coupon. Most of our CLEC
names are only trading a couple hundred basis points wider than the Bells and
almost at par.
RETURN ON CAPITAL INVESTED CALCULATIONS REQUIRE A MULTI-YEAR VIEW
As far as the final issue, return on capital, that is making the rounds these
days. We find it interesting that people have resorted to a 1-year outlook
of incremental revenue relative to incremental capital. That, in a word, is
preposterous. If that analysis was used, we would still be talking on rotary
phones on microwave networks. Never, in our 25 years of experience, has a
major technological changes seen a payback much less than 3 years. However,
on a moving 5-year average, this industry has typically earned a return on
invested capital of roughly 1.5x - 2x its cost of capital.
In the 1980s, when the Bells went from analog to digital switches, it was not
done to simply offer local dial tone. Rather, it was done to be able to
provide services like caller id, call waiting, voicemail that did come to
pass several years down the road. When the long-haul networks went from
microwave to digital radio and then from digital radio to the first fiber
networks in the late 1980s and early 1990s, that clearly was not done to
offer voice long distance. The point is that the capital deployed in this
industry supports revenue streams over a 5-10 year period of new services.
Thus, when you look at the return on capital for this industry, you have to
make a leap of faith on new applications, but our experience shows that new
technology always results in new applications and new services. Thus, we
would argue that over the course of the next 5 years, as the declining cost
of technology coupled with the wealth of applications enabled by the
technology kicks in, the ROIC in this industry five years from now is
actually going to be a lot higher than it is today.
THERE IS A DISCONNECT BETWEEN THE EQUIPMENT VALUATIONS AND SERVICES
VALUATIONS
This leads us to one last point. There is clearly a disconnect between the
valuations of the equipment companies and the valuations of the service
companies. In 1996, if one looked at the totality of market cap between
service and equipment, the equipment companies accounted for roughly 20% of
the total market cap. Today, the equipment companies account for 60%-70% of
the total market cap. More specifically, if the revenue forecast embedded in
the equipment companies to support current valuations are correct, then
unless one thinks the network service companies are completely moronic and
will keep spending money even if the returns are sub-par (which is clearly
not the case), then obviously the growth rate in network services is clearly
quite superior relative to what is being implied in the current stock prices
of the network service companies. There are a couple of scenarios. The
network service companies know what they are doing and the demand will be
there; there will be rationalization in terms of industry consolidation -
which we believe - and thus, returns on capital will be reasonably above cost
of capital and thus the stocks are dirt cheap here. If that is not true, and
the service companies are fairly valued here - which we don't believe, then
look out below on the equipment side.
Our view is that the investment in network technology will continue to be
robust, especially towards the edge of the network and in metro areas, as
well as going beyond the transport layers of the backbone. With cost of
technology 40%-50% per annum, and enabling new applications, we believe
network spending, while not running at a 35%-40% rate as it did in 2000, will
nonetheless continue to grow at roughly a 10% rate give or take each year.
With that, the network service companies in total can see free cash flow out
a few years and increasing returns on capital as the paybacks on this
technology kicks in. That scenario dovetails with the current valuations of
the optical and equipment stocks. Our view is that the equipment stocks are
not overvalued, but rather the network service stocks are woefully
undervalued relative to the long term opportunity.
WE REITERATE OUR FAVORITE NAMES
As far as the names are concerned, everybody knows what our favorite names
are. But our view is that current valuations with the incumbent players
trading at very low relative P/Es and the emerging players clearly trading at
the low end of their historic ranges on forward revenue or net plant
multiples - just like this industry went down in unison. We would argue that
in the next 12 months, a market-weighted index of the telecom service
industry will be significantly higher than it is today across the board. Our
view is that among the incumbent players, WorldCom# (WCOM/$28.44/1M), Verizon (VZ/$43.56/1M) and SBC# (SBC/$45.50/1M) represent the
best combination of value assets and accelerating growth potential.
Regarding WCOM, we continue to believe that WCOM has the best set of assets
in this industry and we strongly reiterate our Buy rating. VZ
and SBC are trading at historically cheap levels and have incremental growth
opportunities coming from DSL and long distance entry.
Given our view of bandwidth, we want to be very overweight the bandwidth
names. Global Crossing# (GBLX/$30.02/1S), TyCom# (TCM/$38.75/1S), Metromedia
Fiber Network# (MFNX/$27.81/1S), and Flag Telecom# (FTHL/$10.94/1H) clearly
represent bottleneck assets. Level 3# (LVLT/$74.00/1S), Williams#
(WCG/$22.88/1S) and Broadwing (BRW/$25.19/1M) clearly represent leveraged
plays on bandwidth. Among the CLECs, no surprise, continue to be McLeodUSA
(MCLD/$12.06/1S), NEXTLINK# (NXLK/$27.00/1S), Allegiance# (ALGX/$40/1S),
Winstar# (WCII/$19.44/1S) and Focal# (FCOM/$21.75/1S) - all of which have
good visibility on current quarters we believe. These business plans are
superbly managed and will have no trouble accessing capital.
NET/NET
We believe Wall Street is allowing the depression in the stock prices to
dictate research. Issues that are being raised are not new and could have
been raised when these stocks were 70% higher. We fundamentally believe in
the growth of this industry, in the potential for value creation in this
industry. But it ain't easy. Anyone who thought that this group would just
go straight up was sadly mistaken. At a time like this, when the valuations
are absurdly low, and there is huge capitulation on Wall Street, we thought
it was a good idea to remind people where we stand. We are very aggressive
on these names. Clearly, on any subset of the names we alluded to, we would
be buying aggressively. |
