The final word on the crash of the telecom market...
"Where there are moderation and patience, there is wisdom."
If you ever wanted an encapsulated account of the rise and fall of the telecom market, you have come to the right place. Other than the recently revealed fraudulence of WorldCom and company--which after all can be found in ALL industries and businesses--the demise of telecom can basically be summarized into three main categories:
The sloppiness of industry participants including the government
The overabundance of the capital markets
The over-forecasted demand for Internet services.
Sloppiness of industry participants
Michael Porter, the famed marketing guru, has said: "As an industry matures, the strategic sloppiness of its constituents is eventually revealed." For the telecom market, there is no more apt analogy than this powerful phrase, and its constituents range from governments to service providers, venture capitalists and vendors.
The government agencies in both U.S. and Europe built a shaky foundation for the growth in telecom either due to lack of experience and incompetence or as a result of greed. The lack of government foresight is clearly evident in the European 3G auctions, where the licensing fees added a healthy dose of cash to the public coffers, yet has almost bankrupt the participants. Eleven of the European Union's fifteen member states issued 3G licenses, which according to EC figures has cost operators over 130 billion euros ($116.7 billion) with little capital left over to actually build the costly 3G networks.
In the U.S., indeed the Telecom Act of 1996 deregulated the telecom market and allowed for competition in the local loop, but with regulations that did not encourage an effective competitive environment. To meet universal service requirements, retail local rates have always been artificially low, subsidized by long-distance access charges and unrepresentative of the real cost of service. The Telecom Act required the RBOCs to resell the last mile at below the already low price to the CLECs. This type of pricing did not give the CLECs an adequate margin and the ability to run a viable business and it did not allow the RBOCs to recover their investments and created disincentives to invest in advanced broadband networks. (SBC reportedly loses $14 on each loop it leases in Ohio.) As a result, many of today's defunct CLECs opted to build their own network infrastructure, which proved too costly, and the RBOCs stayed away from broadband investments.
Of course this problem was not only in the U.S. The European Union, still to this day has not been able to foster a competitive environment and the PTTs like France Telecom and Deutsche Telekom have gone out of their way to stop competition. As recently as last month, a consortium of European competitive operators lodged yet another complaint against the PTTs with the EU.
The Telecom Act led to aggressive network expansion by a variety of service providers, fueling demand and thrusting vendors, VCs and everyone else on the telecom food chain into a feeding frenzy, which resulted in uncontrolled growth and the eventual demise of the telecom market.
Despite the anemic resale margins, the Telecom Act nevertheless gave a huge advantage to the competitive operators in that it allowed them the choice to offer services only to profitable regions. Yet despite this crucial leverage, 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.
Second, the CLECs were a greedy bunch and were more interested in being acquired than providing competitive services to customers. The acquisition game involved expanding the network and the infrastructure to the top 30 to 50 U.S. markets to make the CLEC sufficiently attractive as an acquisition candidate to either a long-distance company or an RBOC.
National infrastructure expansion and fiber deployment obviously translated into a very high-burn rate, overextending resources without consideration for 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 2001 to $2. As a result, less than 20% of about 300 CLECs are currently expected to survive.
So what was the driving force behind the CLEC's national expansion other than dreams of grandeur? For certain the venture capitalists and the private equity firms played an important role in this strategy. These firms had access to a tremendous amount of capital, which they invested fearlessly in the upstart service providers, AND drove them to a national expansion to make them a more attractive acquisition or IPO candidate. In addition, many VC and especially equity firms like Hicks Muse had no expertise in telecom yet attempted to apply their experience with old economy leveraged buyouts to the telecom world.
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 and Cisco amongst others offered large financing packages to upstart 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 in the past five years has now forced them to reduce their corporate fat in the face of lackluster demand. Many vendors gambled on growth by acquisition, acquiring start-ups 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.
The ILECs and the IXCs 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 $6 billion of capital expenditures in lieu of regular operating expenses. Additionally however, IXCs have long been suffering from dwindling long distance revenues, which partially explains WorldCom's desperation. Part of the loss is a result of their own predatory competitive price wars, 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 amassing 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).
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. (To be fair, these divisions were mandated by the government.)
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.
Over-forecasted Internet 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 with estimates of traffic doubling every 100 days. For a while in the 1995-to-1996 timeframe, at the inception of the Internet, these estimates were accurate, but growth dropped to 300% annually after the initial euphoria and then stabilized at between 70% and 150% in the latter part of the decade. 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. Of course, when it was evident that this type of demand was not occurring, the service providers had to resume to price-cutting, which put a further dent in their businesses. The irony of the situation is that despite the millions of fiber lines criss-crossing the country, demand in the local loop still has yet to be met!
The aftermath The three most significant derivatives of the demise of the telecom industry have been staggering unemployment figures, reduced capital availability and loss of confidence in the sector. The telecom industry has reportedly laid off between 500,000 and 600,000 employees.
The dearth of capital is a well-known fact in the telecom world with a $2 trillion loss in market capitalization and $600 billion to $1 trillion in debt. What may not be as equally well known however is the eventual impact of the absence of capital on the introduction of new technologies and services. Not only are start-up 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.
To regain public trust, three events need to occur simultaneously: a surge in carrier spending (bolstered by an improved economy) and debt reduction coupled with improved operations; complete cleansing of management involved in fraudulent activities; and a rethinking of corporate strategies and a return to fundamental business requirements such as: focus on core competencies, focus on customers and quality service, exiting non-essential businesses, focus on traditional metrics such as positive EBITDA, and most importantly ascertaining the quality and integrity of management.
The future The U.S. telecom market is a very strong industry with combined local and long-distance revenues of $285 billion in 2000 and an estimated $422 billion in 2005. 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, and access line deployments have increased from 4.9% to 7.3% a year. This trend is expected to continue especially due to demand in such large developing countries as China and India. Wireless subscribers which were at 246 million worldwide in 2001 are expected to continue to increase by at least 100 million each year through at least 2006. According to Morgenthaler Ventures, "Over the next ten years, the transition to an Internet-based communication paradigm will be complete, [which, this time around,] will truly transform all service and business models".
The drop in spending which was originally forecasted at 15% to 35%, according to Robertson Stephens has actually been at 13% in 2001, 12% in 2002 and expected to be 6% in 2003. RBOCs are expected to spend the same percentage on capital expenses as they had between 1990 and 1995 and between 1996 and 2000. The Bush economic stimulus package will also help future capex expansion.
The expected growth in the telecom market will translate into opportunities for both vendors and service providers. In addition, regulatory relief either in the Hollings-sponsored structural separation of RBOCs or the Tauzin-sponsored RBOC entry into data long distance without first securing Section 271 approval will further propel spending.
In many ways, the downturn in telecom is no different than any other deregulated industry (remember the airline industry?) where the incompetents disappear and give way to more nimble and stronger companies. Products with strong demand will be in wireless infrastructure (both mobile and fixed), the metro optical, optical switches and voice-over-packet equipment and these killer technologies will no doubt generate their own demand.
Expect to see further mergers and consolidations all over the telecom value chain, especially in wireless, long-haul and emerging vendors. Both the wireless and long-haul sectors require economies of scale and mergers are the ultimate solution. Emerging vendors at least for a while, will only be able to market their state-of-the-art technologies to spending service providers through the stability of larger vendors. The trend has already started with Ciena making a small investment in multi-service switch vendor Equipe Communications.
All of these numbers and factoids are meant to express the fact that the telecom market will get back on track, especially once the issue with WorldCom and fraudulence is properly resolved. As the old proverb goes, "Where there are moderation and patience, there is wisdom."
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