from Sanford Bernstein's Tod Jacobs: "Whither Telecom? Our new 'Guide
for the Perplexed'"
HIGHLIGHTS:
1. Telecom merger fury will continue unabated, driven by a pressing
quest for vertical and horizontal scale: key drivers are what you've got and
what you lack (the substance of this report)
2. We foresee four obvious consolidated survivors: WCOM and AT&T are
ahead and now have all the pieces; BEL and SBC are close, and are likely to
see near-term links with DT or FT (and perhaps Global One)
3. Numbers five and six less obvious and more likely to see someone's
shareholders getting diluted: fifth likely to be BLS-QWST-USW-KPN with
continuing need for national wireless; sixth is some version of GBLX with
links to a DT (and continued need for national wireless) or a large BOC
(also solves wireless) or both
4. CLECs/DLECs clear candidates as are few standalone Internet players
and national wireless companies; but most will race against the toll that
competition will ultimately take on standalone players as the
large-scale-multi-service carriers apply increasing pressure across business
lines
INVESTMENT CONCLUSION:
WCOM, T and FON remain outperform. SBC and USW are rated marketperform. In
wireless, Powertel is outperform and PCS is marketperform. Investment
strategy on a broader scale is addressed below.
DETAILS
1. Overview
Recently at a meeting in Amsterdam, a portfolio manager asked us to try to
make sense of what was happening in telecom - the blur of mergers and
ventures, the endless press releases, the rumors, the volatile stock prices.
Just what is the point and why, and how could a non-specialist in the area
attempt to get a view of the forest, even as the trees are in motion. In the
process of trying to explain how the pieces fit, we began drawing a grid of
company capabilities across a white board. Over the course of the next few
meetings, the grid was refined, ultimately becoming the focal point of the
entire European trip. The concept is pretty simple: no telecom company on
the globe was born with all the necessary limbs. Now they're trying to get
them: through grafting, growing, planting, replanting and partnering - you
name it. Moreover, our basic thesis holds that once anybody has everything -
and WorldCom and AT&T are coming awfully close - then everybody needs
everything.
The reason? Because scale works in several important ways. First, high
fixed-cost businesses like telecom provide natural advantages for large
players if they can operate efficiently (i.e. being large doesn't imply
scale advantage if the company can't capture it - like pre-Armstrong AT&T,
whose SG&A was out of control; but only large companies can be
scale-advantaged players). The long distance industry's woes in 3Q99
demonstrated this fairly well. While all companies saw either company- or
analyst-driven revenue downdrafts (i.e. growth rates for 2H were lowered),
2H earnings expectations at the small guys got crushed (IXC, Teleglobe,
Frontier, Star); earnings expectations at the largest of the small (Sprint)
got tarnished; and the large (T and WCOM) remained intact. Why? Because the
large guys have the ability to take out costs faster. Perhaps more to the
point: the fact that the large guys have been taking out costs for a while
now (2 years at T; 1 year at WCOM) has in a sense created the pressure on
the rest of the industry as part of the cost savings is being continually
channeled back into lower prices, even as margins rise. And given that
roughly 80% of long distance costs are either relatively fixed (e.g. part of
network cost, most of SG&A) or scale-driven (e.g. access costs, which are a
function of network breadth and depth and volume), the operating leverage
works lethally against the small guys as pricing drops. Especially as
historic pricing provided a comfortable umbrella.
The phenomenon is multiplied as carriers gain the ability to offer multiple
services over ever-more-integrated pipes, thus taking greater advantage of
network and marketing scale, and creating the possibility of multi-product
discounting. Thus the lead increases. And while successful integration is
not a forgone conclusion (that is, execution is most definitely an issue),
how many players can risk the outcome if even one of the scale players is
successful?
Predictably, the result is a mad rush to gains customers and capabilities.
Some, like the AT&T and the BOCs (especially SBC and BEL, whose
nationalizing and globalizing strategies are under way) will rely on massive
customer bases and huge balance sheets to smooth the way to otherwise
inherently dilutive acquisitions of higher-valued companies; others will
make use of their expensive currencies (QWST, GBLX); while still others will
make use of both (WCOM). Either way the trend toward massive consolidation
is irreversible, and will likely be completed long before investors have a
chance to catch their breath: we'd say within 18 months for the most
significant mating.
What follows is, we hope, a guide toward the inevitable. Sort of a
how-to-fill-your-holes-if-logic-prevails way of looking at the world. On the
latter point: logic doesn't always prevail. Managements have ways of either
panicking or doing less-than-shareholder-friendly deals in order to maintain
their own control and to avoid being left out (especially professional
non-owner managements). Those are a bit harder to forecast. But clearly the
more you're missing, the more likely orderly and non-hugely-dilutive (let
alone accretive) deals will prove elusive.
With that, then, we present our "Telecom Guide for the Perplexed" - a.k.a.
"How can I get a semblance of a notion of what's going on without having to
raise my hand and ask questions in public?"
2. The categories
While arguments will obviously be made relative to the categories we've
chosen as well as to our system of grading within categories -- zero stars
(no positioning) to 4 stars (best positioning) -- this is our best attempt
to capture the primary issues (see Exhibit 1: the grid).
* "Incumbent local" assets (shown as % of US households served): i.e.
are you an RBOC or GTE or a smaller ILEC, such as Sprint, still enjoying
roughly 99% market share in consumer local and nearly 95% market share in
business local - and the monopoly margins that accompany it.
* "National competitive local," - that is, do you have a CLEC strategy
in place for business and for consumer customers. This category is relevant
to all non-ILECs on a nationwide basis, and for ILECs as it relates to
out-of-region capabilities.
Exhibit 1
<<...>>
* "Hi-speed consumer data," which does not necessarily accompany a
CLEC strategy (though all ILECs have such strategies in-region). That is, if
your consumer local strategy relies primarily on resale of RBOC local
service (e.g. WCOM in NY), that doesn't imply hi-speed data capabilities.
Hi-speed requires a cable model, DSL or MMDS strategy of some kind.
* "LD Network" is a simple run at whether you own a nationwide fiber
network (or are trying to build one).
* "LD Scale" gets at the question of customers, capabilities and
possibility or realization of a low-cost-provider position. In addition, and
somewhat imperfectly, we've included in this category the standard LD data
products (ATM, frame, LD private line). Imperfection lies in the fact that
there are non-traditional LD players with real data businesses (USW
out-of-region in frame relay, Intermedia, Equant and others).
* "Internet Backbone" rates players as national backbone players, with
both wholesale and retail capabilities and customers (Qwest has lots of
capacity, some products and an aggressive strategy; WorldCom has a huge
existing customer base and global scale and capabilities; AT&T enters late,
but is building a strategy and leveraging its existing LD and data customer
base and extensive network assets).
* "Regional Wireless": how are you positioned at least within the
region that you serve?
* "National Wireless": self explanatory.
* "Global": do you have capabilities (e.g. WCOM) or at least a
well-defined and developing strategy (e.g. T & BT) for providing end-to-end
service for multinationals, at least throughout NA and across Europe?
3. The Company Descriptions
"Long Distance Companies"
* AT&T
Haves: The company is one of two in the industry (along with WCOM-FON) that
has assembled strategies and/or assets in all the major product sets. In
national competitive local, the company serves business customers through
Teleport, the number 2 CLEC. In residential, the company has invested
heavily in cable as the preferred long-term means of serving customers;
however, the fact that cable will only begin rolling commercially in a
meaningful way across 2000 and into 2001 means that the company will use
UNE-P and UNE-L (both low-cost resale strategies of RBOC local voice
services); the company also hopes to fill in with fixed wireless as the
economics become attractive. Hi-speed consumer data will come wherever cable
or fixed wireless is deployed; UNE-P consumer has no obvious associated data
product. Relative to LD, the company is one of the true 2 scale players.
Internet assets are in place, but the company is coming from behind relative
to products and customers; so acquisitions aren't out of the question. The
company is national in wireless, though some PCS markets are still in
start-up phase. And global is being developed on a wireline and wireless
basis with BT.
Have-nots: mostly a question of successful execution and integration of
stated strategies.
In short, no requirement for major acquisition.
* MCI WorldCom
Haves: The other true scale player, MCI WorldCom has lined up the
pre-eminent set of global wireline assets, especially regarding Internet,
business competitive local and global, where the company's ability to
provide on-net services across NA and into Europe and to a much lesser
extent Asia is unparalleled, and will remain so for some time.
Have-nots: Weaknesses are two: the company is half pregnant in consumer
local, where it has invested modestly in both UNE-P (as it has become
available in NY and to a lesser extent, TX - though recent FCC action have
mandated ultimate ubiquity of residential UNE-P), and, more recently, MMDS,
a fixed hi-speed wireless solution for data and possibly voice (though
Sprint appears to be further ahead on utilizing MMDS for voice services
through its ION effort). The other obvious large hole lies in wireless,
where the company effectively has nothing other than some very weak resale
sales that came along with MCI.
With Sprint, the deals are done. Longer term the company will need an
out-of-North-American wireless strategy - perhaps through a Vodafone merger.
* Sprint
Haves: The company was early in data and Internet and has built from scratch
a premier nationwide wireless business. In addition, the company controls
incumbent local exchange service to about 5% of US homes.
Have-nots: In competitive local the company takes a clear backseat to both T
and WCOM; indeed the ION local services for business and residential are
only seeing the earliest stages of rollout (large business runs on rented
fiber rings; small business and residential will utilize MMDS and DSL as
transport). The company has a long distance network, but lacks scale
relative to the big guys (as evidenced by higher access and SG&A costs). In
many ways we view Sprint as the largest of the small rather than the
smallest of the large; thought to be sure it's the number three player (and
well ahead of numbers 4-800) relative to large business services. Global is
at best a disaster, with Global One virtually dysfunctional for the past few
years, primarily for management and political reasons (mis-aligned partners
since the beginning).
WCOM fills the major lacks.
* WCOM+FON
This is where the action is: WorldCom offsets Sprint's weaknesses relative
to LD scale, business competitive local and global. Sprint brings WCOM
wireless. And, combined, the company can provide a distant third place spot
to the RBOCs and T in consumer bundled services.
* Qwest-USW-KPN
Haves: USW brings ILEC service to about 11% of the nation's homes and
businesses, including a high-speed data strategy and an out-region
frame-relay business in concert with Intermedia. The company has a new
premier network, but has not yet attained to scale relative to customer
counts, traffic and network buildout; same with Internet (though the company
is moving fastest among all the new carriers with respect to both).
Have-Nots: The company has precious little so far in competitive
out-of-region local, though QWST is in the process of building, buying and
swapping for local fiber rings. Wireless is a gaping hole; and global is
just taking shape with the KPN venture in Europe.
Company needs to get taken out or make further acquisitions, especially in
wireless and possibly in competitive local.
* Global Crossing-Frontier
Haves: Frontier brings with it a small ILEC base in Rochester. The company
has LD network assets in place in NA and from NA to numerous points abroad,
and to a lesser extent in Europe (though the recent Racal acquisition will
add capabilities in the UK; and the company has begun developing interesting
strategies in Japan along with several partners).
Have-nots: GBLX is by no means yet a scale player in LD or Internet backbone
(though Frontier has a premier Web hosting business). The company has almost
nothing in competitive local for both business and consumer. Wireless is
non-existent outside of upstate NY.
Needs are similar to Qwest, just more so.
* Level3
The company has ample capital and is building furiously across both the US
and Europe - both backbone and local connectivity -- but cannot yet really
be put into the category of a functional player (though much like Qwest we
expect Level3 to move up in a hurry when the assets are in place. Even when
the network goes live, buildout is likely to be relatively piecemeal.
Consumer retail appears not to be part of the strategy (though the company
owns about 29% pro forma of consumer CLEC RCN). Wireless is non-existent.
* Williams, Enron, etc.
Of the smaller, in-build-process players, Williams has a shot of attaining
scale relatively quickly given its position as premier LD provider to SBC
(once it enters the business), which owns a small piece of the newly public
company and has an agreement under which it will help to develop the network
and products. Meanwhile, Williams is moving into position as a carrier's
carrier as the network comes on line. Enron is also producing a carrier's
carrier business on its new and developing network. We'd also include
IXC-Cincinnati Bell in this group: a new LD network trying to develop a
customer base, but in this case married up with a small, regional ILEC.
"Local Companies"
* BEL-GTE
Haves: Of all the local companies, BEL-GTE is closest to holding a complete
North American set of assets: 37% of the nation's incumbent local assets; an
LD network (GTE), albeit one without scale and much demonstrated capability,
particularly regarding business customers; a premier Internet business
(GTE/BBN) and a national single technology (CDMA) wireless business in
concert with Vodafone/Airtouch.
Have-nots: Out-of-region local is extremely sparse, though we expect the
company to have to commit to some type of out-region attack strategy similar
to SBC's. Global is fairly weak (some interesting stand-alone investments,
but not a seamless strategy), and likely in need of a large European
partner.
Company may deem it necessary to continue to invest in CLEC assets (as it
did recently with Metromedia Fiber Network); but largest holes would be
filled by joining forces with DT or FT, perhaps with Global One thrown in.
* SBC-AIT
Haves: The company controls about 32% of the country's ILEC assets. Wireless
is more complex: the company is approaching a national strategy, but lacks
NY and lacks a single-technology digital roaming capability (California is
GSM; rest of country is TDMA; most of AIT's CDMA businesses were sold to GTE
on the merger close). Most likely scenario, in our view, would be a strong
roaming agreement (similar to BEL-ATI of old) with the now-consolidating GSM
companies, who need SBC's California capability in exchange for NY; merger
is clearly not necessary. As to global, the company towers above the other
RBOCs, with strong, partial-control investments in Canada, Mexico, Denmark,
Belgium, Hungary and South Africa (with incumbents) and further investments
and/or arrangements with numerous smaller providers in Europe and Asia. In
addition, a relationship with Teleglobe put AIT into the business of
international LD resale. And while the numerous international assets haven't
yet been knitted into a seamless capability relative to serving
multinationals, the toe-holds are pretty strong and the company clearly has
a base to move in that direction.
Have-nots: As to the rest of the country, SBC has announced its
"national-local" strategy, but it's less than clear exactly what the scale
is likely to look like and whether it will be all build/lease, or some buy.
While the company doesn't own an LD network, it does have a small
investment and some development control in the new Williams network. Like
the other BOCs SBC-AIT already has some LD capabilities in-region (they've
effectively connected the dots in advance of LD entry, allowing for a so-far
undetermined level of capability). The company clearly lacks LD scale since
Williams itself lack it; nor is there a significant Internet capability.
Like BEL, SBC would provide a suitable marriage partner for DT or FT, also
potentially in concert (no pun intended) with Global One.
* BLS
Haves: The company has a strong and growing region in the form of the SE
United States, both with respect to wireless and wireline (including data
and some video).
Have-nots: BLS's historically provincial strategy (other than in Latin
America) strongly disadvantages the company in the race for national -let
alone global -- scale and capabilities. That is, outside of its region BLS
has precious little to show: no LD (aside from a relatively ill-defined
benefit from its 10%-going-to-3%-pro-forma Qwest investment), no Internet,
no wireless.
Long term, BLS has relatively few options (though it can grow earnings for a
time by continuing a SE focus). Logic would perhaps dictate getting taken
out by Qwest post USW (that way the high-multiple company takes out the low;
synergies are possible by the USW part of the merger); however, a desire for
control will likely work any deal the opposite direction. Post an LD-related
merger the company will still need wireless and perhaps CLECs. Thus should
BLS desire control, it's got at least two large and expensive mergers ahead
of it.
* CLECs-DLECs
These small companies benefit from RBOC foot-dragging (e.g. in rolling out
DSL) and RBOC pricing (subsidy laden business prices; even DSL for business
will be priced high to protect the T1 business). Business mix includes some
LD voice (mostly resale) and data in addition to local voice and data
services. Management talent is all over the lot; but the assets have proven
and will prove strategic for numerous other players. The DLECs may have a
standalone strategy as front-men for a host of ISPs and LD players in the
DSL space; the CLECs largely exist to be bought.
"Wireless Companies"
* Nextel:
It's got national business-focused wireless, though capacity and migration
to 3G will become ever more important issues. Nothing else relative to North
American assets. A clear take-out by a Qwest or GBLX most likely; could bind
itself together with a group of CLECs and DLECs, but who'll get the premium
and who'll get control?
* GSM Companies:
With the merger of Voicestream, Aerial and Omnipoint, the long-awaited GSM
consolidation is well under way. Powertel would help round the SE footprint.
But the group needs California. Luckily, SBC needs NY. Thus a
self-interested roaming alliance seems obvious. The company will likely be
taken out by whichever LD upstart doesn't take out Nextel.
"Internet Companies"
* PSINet
One of the few pure plays, the question is when more than if. For any of the
Internet players buyers would included just about everyone with the
exception of MCI WorldCom and perhaps BEL (post GTE).
* Cable & Wireless
The old MCI Internet business, C&W's North American Internet business is
part of what appears to be the company's global focus on and narrowing
towards data and Internet assets. We expect the company to have a brighter
future as part of a behemoth than as a stand-alone.
* Sprint Internet
Everybody will want it; but management probably won't offer it to anyone
considered dangerous (e.g. AT&T).
"Foreign Companies"
* BT, DT, FT
Only BT at this point has a well defined global strategy (with AT&T in both
wireline, building on the existing Concert venture, and wireless) that
includes North America. DT and FT are nowhere, especially with Sprint's
imminent departure from Global One. In our opinion, If they're smart,
they'll find a way to merge or at least knit themselves together with SBC
and BEL. The sexy, but more dilutive and far less logical strategy would see
acquisitions of GBLX or QWST in tandem with or followed either by a wireless
(Nextel, GSM) acquisition. The other way would see a GBLX takeout and then a
link-up with BEL or SBC to avoid having to make an expensive wireless deal.
* Smaller PTTs (Telefonica, Telecom Italia, etc.)
Cannon fodder for the big guys.
4. Who Needs Who?
Exhibit 2 summarizes the needs and wants of the major players by category as
well as offering up a view of the available supply. In short, an awful lot
of players need an awful lot of capabilities, and most of the lists of how
to get them are short. Hence, we expect the pace to be frenzied for some
time.
--more--
Exhibit 2
<<...>>
5. What Will It look Like?
When all is said and done, we expect that there will emerge maximally 6
players in the North American theater (Exhibit 3); perhaps just 4-5 should
QWST or Global Crossing get consolidated in some fashion (e.g. by merging
with each other or with SBC or BEL - though GBLX will be easier given the
difficulty of another horizontal merger at either BEL or SBC going forward)
- a highly logical endgame. At least the first 4 are relatively easy:
* AT&T in a consortium with BT, the North American Cable industry, and
eventually, probably NTT (which may view AT&T as friendlier than a by-then
attacking WCOM).
* MCI-WCOM-FON, perhaps with Telefonica given an existing and friendly
relationship. Ultimately the company may have to consider merger with
Vodafone relative to global wireless.
* BEL-GTE-Vodafone North America. Company will likely wind up with DT
or FT and perhaps Global One. Fill-in acquisitions will include CLECs and
small data players. Wildcard is whether company will need more LD firepower
(e.g.. GBLX) as time-to-market quickly becomes an issue.
* SBC-AIT-Williams-GSM Roaming. Company claims that it doesn't need to
own LD, but control may well become an issue, especially as the company
moves up from consumers and small business into large business and
multinationals. Whichever of DT and FT doesn't get together with BEL will
wind up here, again possibly with Global One. Fill-ins may prove numerous:
CLECs for out-region, an Internet player.
* Qwest-USW-KPN-BLS?-NXTL or GSM? Entering the realm of the less
obvious, the most likely consolidation involves BLS and then NXTL or the GSM
companies. As we noted above, Qwest should be the buyer; BLS probably will
be.
* Global Crossing-FRO-Racal-NXTL or GSM? Even less clear is the fate
of GBLX. Company is occasionally rumored as take-out by DT, which could of
course then merge into or join with BEL or SBC. Otherwise, a wireless
takeout will be necessary.
Exhibit 3
<<...>>
6. Investment Strategy: What do I do in the Meanwhile?
For the nimble and non-faint-of-heart, playing the take-outs is a fine
strategy, though not one that will allow for much market cap: PSINet in the
Internet space, a basket of CLECs and DLECs, the wireless guys. The risk is
that the takeouts don't happen quickly enough and competition takes a toll
first. Such was the risk with Sprint, which was already beginning to feel
the stress on earnings of its lack of scale and need to invest. Such was the
case with USW as well, where the pursuit of revenue growth was taking a hard
toll on earnings and the stock (especially given the historic EPS and
dividend focused shareholder base). GBLX and QWST obviously come to mind as
well, but LD pricing, should it step down again, could have significant
impact on expected revenue growth.
The beauty of the large LD players - AT&T and WCOM - is that the deals are
nearly done (at least they've already been announced); the companies are now
focusing on execution and integration. WCOM is the core holding; T is the
cheap one, but has a far rockier road to hoe over the next two years,
especially given pending RBOC entry. Both are rated outperform.
In the near term the RBOCs have more catalysts than the LD companies (where
pricing problems have not gone away despite the fact that the street is at
least temporarily ignoring them) relative to LD entry and DSL rollouts. The
most logical are BEL and SBC given the maturity of their strategies and
lesser need for highly dilutive further investments. Risk in both is that
the core voice business is just now coming under attack (though BEL is
further along in the process than SBC). With expected slowing, the vast
majority of revenue growth will be driven by new businesses, with far less
certain margins. Our investment rating on SBC remains marketperform pending
clarity (which we should receive today) of the impact on earnings of the new
local data strategy.
Potential dilutors: BLS, DT, FT - though we have offered ideas for how each
could evade expensive acquisitions and add to shareholder value in the near
term.
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