Overwired world: telecom's crash
For investors, consumers, more trouble ahead
By Dori Jones Yang
When mobile phone giant Nokia announced last week it would miss both sales and earnings targets this quarter, its stock took a 19 percent nose dive. But by day's end the broader stock market had shrugged off the news. In the battered telecommunications field, bad news isn't news–it's the norm.
While dot coms cornered attention–and blame–for the stock market boom and bust, telecom firms attracted even more money, tapping debt as well as equity markets, and their wipeout has been far more disastrous. For investors, it's a blood bath that's not over. For consumers, it's leading to higher prices, at least in the short run. And for the country, it raises the question of whether our great advances in communications technology are now stalled.
So far this year, U.S. telecoms have defaulted on $15.8 billion and eliminated 103,000 jobs–more than double layoffs in the E-commerce field. The most recent high-profile collapse came on May 31, when PSINet, a provider of Internet access and Web hosting services, filed for protection from creditors. (At the height of its hubris in 1999, PSINet secured rights to name the Baltimore Ravens football stadium, promising to pay $105 million over 20 years.) Ten days earlier, Teligent, once a promising provider of wireless services to businesses, sought Chapter 11 protection, its stock having crumbled from a peak of nearly $100 to 56 cents. The month before, broadband service provider Winstar Communications declared bankruptcy, wiping out $6 billion in shareholder value and leaving a $2.2 billion debt.
Investors can expect more bad news to come: The telecom sector has more than $650 billion in debt, and analysts predict that more than $100 billion of that may end up in default. Individuals who checked the "aggressive growth" box for their pension funds may not have realized just how much of their money was backing shaky, little-known telecom companies. Many such funds have suffered steep declines–in large part because they invested heavily in this once hot sector, where valuations of smaller companies will probably never rise again. "Technology is more cyclical than people thought. People lost sight of that," says Dean Kartsonas, 36-year-old portfolio manager of the Federated Communications Technology Fund, which has lost more than 70 percent of its value since its peak.
How did the industry get into such a mess? Experts point to a confluence of factors in the late 1990s: deregula- tion, technology advances, and the rise of the Internet. And while these factors opened up vast new markets, too many players–each acting rationally–sought the same business. "They all thought they were going to win," says Jeanne Schaaf, a telecom analyst at Forrester Research.
Passive neglect. The overbuilding boom began with the 1984 breakup of AT&T into seven regional "Baby Bells," each with a monopoly on local phone service, leaving Ma Bell itself with long-distance service. When the 1996 Telecommunications Act required them to open local networks to competitors, the Bells began to consolidate in self-defense. Now the surviving "dinosaurs"– BellSouth, Verizon, and SBC Communications–plus Qwest, a long-distance company that bought out U S West, are having the last laugh. Through foot-dragging or passive neglect, they have protected their turf, frustrating competitors seeking access to the "last mile"–the copper wires connecting each home and business.
The regional Bells also went on a spending spree to modernize their infrastructure. ("They had to," says Jeff Kagan, an independent industry analyst. "If they hadn't, the markets would have crucified them.") But the brash new upstarts, the so-called competitive local-exchange carriers (CLECs), were also borrowing heavily to build networks. In some large cities, as many as 15 local carriers competed with the regional Bell, plus eight to 10 companies supplying phone service to offices.
Having completed a third or half of their networks, many carriers–even those with strong management such as XO, run by former MCI executives–found they could not raise enough capital to complete their build-outs. "None said they would be profitable in two years," explains Daniel Ernst, a Washington, D.C.-based telecommunications consultant. "They said five to eight years, and the market signed off on that. But a few years later, the market changed its mind and said, 'If you don't have funds in the bank account to make it till then, we're sorry.' "
At the same time, the Internet's rapid rise ballooned demand for alternative long-distance lines for high-speed data. Global Crossing, Williams Communications, Level 3, and 360networks swiftly laid thousands of miles of optical fiber–creating huge overcapacity. Each alone could carry the entire world's traffic.
And when the regional Bells seemed slow in offering high-speed Internet access via DSL, another set of competitors popped up–including Covad, NorthPoint, and Rhythms NetConnections. They scooped up routers, switches, and such from the likes of Cisco, Nortel, and Lucent and began offering DSL service. But so far only about 3 percent of U.S. homes have DSL service, and it's proving unexpectedly expensive to implement.
Meanwhile, the wireless side of the industry began to sizzle. Before 1994, the FCC allowed only two cellular carriers to operate in each metro market–usually the local Bell and a long-distance carrier such as Sprint. Once the FCC opened the markets, new carriers such as VoiceStream and Nextel jumped in. In some cities as many as seven carriers now compete. Price wars have benefited consumers, but most in the industry agree there is not enough business to sustain so many competitors. Still, U.S. wireless firms look solid compared with those in Europe, where companies spent a jaw-dropping total of $100 billion-plus to buy wireless licenses in government auctions and now find themselves forced to delay a planned new generation of wireless technology.
All this is bad news for Finland's Nokia, the globe's largest mobile phone supplier. But telecom's troubles feed back to many other high-tech equipment suppliers as well. Cisco, Nortel, and Lucent, for example, were so eager to grab orders that they offered increasingly risky vendor financing loans. Late last year, struggling upstarts simply stopped ordering equipment, and the Bells, with less competitive pressure, sharply cut back orders, too. "Capital spending hit a wall," says Mark Bruneau, president of Adventis, a Boston-based consulting firm. "It will take a few more quarters of Pepto-Bismol to digest the huge overindulgence in technology."
Survivor game. The industry's stomach will not be easily soothed. Analysts see more weak firms failing while the strong pick and choose those they want to buy out. When the shakeout is over, perhaps in 18 months to two years, only a handful of local competitors will survive in each market. This pattern, executives point out, is not unlike that of the railroad and automobile industries, where dozens of early competitors disappeared and a few large firms prevailed. "There's a survivor game on right now. The weakest links are being eliminated," says consultant Bruneau. "We will end up with fewer competitors but cheaper prices–not because of bullish deregulation by Washington but because of advances in technology."
But cheaper service is not a sure thing. In fact, less competition may lead to higher prices. BellSouth and SBC have recently raised fees for DSL service. America Online has announced an increase in its monthly fee from $21.95 to $23.90. IDC analyst Mark Winther predicts that both quality and customer service may well decline. Now that the incumbent Bells have won, he says, they have no incentive to pursue broadband or third-generation wireless technology aggressively. High-tech companies will continue to innovate, he predicts, but will focus on selling advanced technologies out- side the United States. "We have a real risk of ending up with a second-class tele- communications infrastructure," says Winther. "Europe, Japan, even China and India are going to leapfrog the U.S. and develop broadband."
Others find such negativism unwarranted. "In the telecommunications sector, irrational exuberance was replaced by irrational pessimism," says William E. Kennard, former Federal Communications Commission chairman and now a managing director of the Carlyle Group, a private equity firm. "Ultimately the market will emerge healthier." Industry veteran Matt Desch, chairman of high-speed wireless provider Airspan Networks, also thinks the current shakeout may end well. "It's a little bit like a forest fire," says Desch. "It cleans out the deadwood and creates a healthier environment for everyone down the road." After the firestorm of recent months, he can only hope so.
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