Telecom's Future
Washington-based analysts see industry shifts in the U.S. and globally
An Interview With Scott Cleland and William Whyman ~ The Precursor Group is just that: an outfit dedicated to
identifying trends and issues in industry, technology and policy that will have an impact on telecommunications and
technology long before others make the connection. Even better, it's an independent research boutique, based in
Washington, D.C., international in scope, from which its institutional clients take away not only the most informed
analysis around but also the most unvarnished. Founded by a couple of insiders' insiders, Cleland and Whyman,
Precursor's work offers a perspective missing from much that passes as research, drawing on the team's experience --
including international communications expert Rudy Baca -- in government and industry as well as on Wall Street. We
caught up with them last week for a sense of what's on the horizon under the new Administration and where investors can
expect to find opportunities.
-- Sandra Ward
Barron's: What, if anything, changes for telecom policy under this new Administration and Federal Communications
Commission?
Cleland: The Administration will be much more deregulatory, much more skeptical of industry ownership caps for cable,
broadcast and wireless. This is going to be a consolidation-friendly Administration and an infrastructure-friendly
Administration for both the local telcos, cable, and the wireless providers.
Q: When you say infrastructure friendly, what are you referring to?
Cleland: They are going to want to encourage deployment of the incumbent cable and telephone communications
infrastructure by getting out of the way and not microregulating.
Q: What else should investors be on the lookout for?
Cleland: The change in the chairmanship of the House Energy and Commerce Committee. That's a huge shift because the
prior chairman was blocking a majority sentiment to reopen the 1996 Telecom Act. New Chairman [W.J. "Billy"] Tauzin
[Louisiana Republican] wants to reopen the Telecom Act and modify it in a way that would encourage the Bells to
promote deployment of DSL. There will be House legislation this year. It is going to catch many investors by surprise. It
will pass quite easily, potentially overwhelmingly, sometime this year. That will change the dynamic, and it will force the
Bush Administration to respond. It will also force the Senate to respond. It is very difficult for legislation to pass, and so
investors should not necessarily expect the Telecom Act to be revised this year or next. However, they should realize that
the House will pass legislation, which will change the tenor and change the mood of the sector.
Q: This is an acknowledgment that the Telecom Act of '96 was a failure?
Cleland: It is an acknowledgment that the Telecom Act is seriously troubled. The Telecom Act has proven to be a lousy
investment thesis. Investors generally interpreted the competitive thrust of it to mean the incumbents would lose and the
insurgents would win. Incumbents have taken almost everything that the FCC and the CLECs [competitive local exchange
carriers] have thrown at them and they have done just fine. The CLECs, meanwhile, are code blue.
Q: Is this because of a failure to enforce the act, or a failure of business models?
Cleland: It was a failure of the economic premise of the Telecom Act. The Telecom Act assumed that local competition
could emerge. The Telecom Act was supposed to lower prices for consumers. It raised prices for consumers. It was
supposed to encourage innovation. It hasn't, at least with regard to the incumbents. It was supposed to encourage
deployment of advanced services. It really hasn't accelerated DSL deployment much.
Q: Why is broadband deployment such a problem?
Cleland: Broadband deployment is driven by distance from the existing network. To understand where deployment will
occur you have to understand the geography of existing deployment. Where is the telephone company's central offices?
Where is cable? Wherever that is, broadband is being deployed. There are three distinct markets. In the large business
market, almost all companies that want broadband already have it. In the residential market, only 6% of residences have it
and about 73% of that is being provided by cable and about 26% is provided by DSL. Interestingly, the small- and
medium-business market is almost exclusively DSL and it is not getting deployed at all. That's because small and medium
businesses tend not to be downtown, they tend to be geographically dispersed, and because they are dispersed, they have a
very high demand for broadband. Yet they are the least likely to get it. This is important and relevant because the small and
medium businesses traditionally have been one of the greatest sources of employment and economic growth.
Q: What's hampering the deployment? Is it simply the Bells refusing to cooperate with the CLECs?
Cleland: People think broadband deployment should just happen because they have been hearing that convergence is
wonderful and convergence is a good investment theme.
Whyman: DSL costs a lot more, takes a lot more time, and is operationally more difficult to do. That's on the supply side.
On the demand side, there haven't been a whole lot of great applications out there for which people are willing to pay. We
are talking about price points of $40, $50, $60 a month. What are the great applications? There aren't a lot that exploit and
use broadband. Most time is spent on communications applications such as instant messaging. We are not seeing tons of
very intensive video conferencing or streaming media, or things like that. There is no killer ap on the demand side.
Q: Was DSL oversold?
Cleland: Clearly. The Internet and the dot.com phenomenon made people perceive that broadband was just around the
corner. And broadband required a reconstruction, a re-engineering, of our two basic networks: The phone network had to
be powered up to a higher bandwidth, and the cable network had to go from one-way to two-way. In many places, the
telephone plant and the cable plant are abysmal. And so -- this is another reason for the industry's hangover -- in addition
to going on a regulatory binge, it went on an investment-banking binge where an enormous number of lousy business
models got funded. Too many competitors got funded for a high-fixed-cost industry.
Whyman: The cluster of industries around IT [information technology] made up 30% of all U.S. economic growth from
1995-99. They represent roughly 10% of the economy, yet they contributed three times their size to economic growth. IT
investments rose to 46% of all capital equipment investment by 1999. That was unsustainable.
Q: Let's get back to the legislation to be introduced this year. What's the goal?
Cleland: The goal is to spur local telecom investment, to deregulate the local telcos for data. If there is going to be
something that pulls this sector out of its funk, it will be the Clydesdales that are the Bells. They are going to be the big
horses, the ones that do the major spending and the major deployment. One of the fallacies in the market that led to the
euphoria in the past was that competitors -- small companies and next-generation carriers -- could carry the sector. Yet
they were generating a minuscule percentage of the overall revenues. Telecom is the land of the giants. It's scale. We don't
have eight or nine or 10 auto companies or large steel companies or large aluminum companies. The economics of telecom
demands scale. Very few niche players are going to prevail long term. They don't have the gross-margin capability to make
it work.
Whyman: The whole incentive structure of the Telecom Act is problematic. Why would one company sell the tools to its
competitors to beat it in its own game? The Bells are being forced to do that by regulatory fiat. Surprise, surprise, they did
it haltingly.
Q: Are you guys completely writing off the CLECs at this point?
Cleland: Yes. As an industry model, the CLECs are not a very sound model. The standard investment-banking line is that a
few will survive. That's because a few have private investors who will continue to subsidize their lousy business models. I
am highly skeptical of the CLECs.
Q: Let's go back to your point that there is less demand for some services than is widely assumed and there is no killer ap.
What about data traffic?
Cleland: There's a lot of hype about data. We call it datatopia. We don't expect the data-growth stories, the Cisco
data-carrier business or the next-generation data carriers, to be able to grow at hypergrowth rates. Data growth is what it is.
The market hyped it as being a lot higher and a lot faster than was the case in reality. For most investors, the conventional
wisdom held that data traffic growth was doubling every three to four months. That would suggest an 800%-1,600%
increase in the annual rate of data traffic growth. The problem is the actual annual growth rate for data traffic is closer to
100%. That's very fast growth, but it's not the hypergrowth rate of 800%-1,600%.
Q: So who benefits from data traffic at this point?
Cleland: One of the big challenges for data transport going forward is that it was built upon a not-for-profit model. We
forget that the Internet was designed by the Defense Department to support academic institutions where everybody paid
their own way. It was not a commercial mechanism to sustain itself.
Whyman: We believe in data growth, but data profitability is elusive. No one at our conference had an answer for how
people make money off data. People have assumed that volume growth is equal to revenue growth. What we are seeing is
a huge increase in volume counterbalanced by equally substantial drops in pricing. And the only way out of that box is to
provide some kind of differentiated service. But it is going to take a while before that happens.
Q: So where should investors focus?
Cleland: The lesson for investors here is that the system is set up to collect money at the access point. Companies that
have control of the access point to the customer, whether it be the phone company, the cable company or the wireless
company, are going to be able to capture the value. The people that are involved in transport, the long-distance companies
or the next-generation data carriers, are in big trouble. The value is migrating to the local access, away from transport in a
big way.
Q: Let's talk about wireless. What about the spectrum scarcity issue?
Cleland: Wireless is one of the most interesting investment issues in the year ahead as a result of the new Bush
Administration. We believe that the current spectrum caps will be eased substantially later this year. That's a very big deal
for investors.
Q: Explain the spectrum-cap issue, if you would.
Cleland: Right now there is a limitation that no one company can own more than 45 megaherz of spectrum in a large city,
or 55 megaherz in a rural community. The result is companies that have the most customers have the least quality because
they have the least spectrum per customer to provide. The caps were designed to create a lot of competitors. However, it
has resulted in sub-optimized use of spectrum. When the spectrum caps are lifted, it will greatly increase the utility of
spectrum and therefore the value of spectrum. This could be one of the catalysts that help telecom eventually come back.
Q: Is there enough spectrum available?
Cleland: There is clearly a spectrum scarcity. But the first order of the day needs to be allowing people to more efficiently
use the spectrum that exists. There is a lot of spectrum woefully underutilized by small companies that don't have the
customers.
Q: How does this play out?
Cleland: We think it is a very positive catalyst for the whole wireless sector because the spectrum is going to be worth
more. Smaller companies will most likely be taken out. Large companies will be worth more because they will have
spectrum more efficiently utilized. There is hidden value in wireless right now.
Q: What are some names to consider?
Cleland: Among the large players, you are looking at Verizon, Cingular, AT&T Wireless, Sprint PCS, Nextel and
VoiceStream. The little guys are everybody from Alltel, U.S. Cellular, Western Wireless, CenturyTel, Dobson, Rural
Cellular, PowerTel, Arch Communications and Metrocall. We think AT&T Wireless will be an interesting issue because
they will be enjoying the lifting of the spectrum caps as they get spun off from AT&T and their flexibility will increase.
Whyman: For all those people who are counting on wireless to be the next thing that powers Internet applications forward,
they better hope that spectrum shortage gets resolved because it really is a key limiting factor.
Q: Are you referring to 3G?
Cleland: If you don't have enough spectrum, 3G is a spectrum hog. It will chew up and cannibalize your profitable voice
spectrum. Spectrum caps need to be lifted in order to provide head room for 3G to be deployed.
Q: What about the extra spectrum held by the Department of Defense?
Cleland: The Department of Defense is the holder of most of the spectrum that people want. I would tell investors not to
hold their breath for the Defense Department to give up choice spectrum. It is not in their interest.
Q: Where does the extra spectrum come from?
Cleland: That's the whole point. There is not a lot of extra spectrum coming down the pike, and that's why spectrum caps
being lifted is so imperative.
Q: Do we need 3G? Companies keep saying that 2.5G is okay by them.
Cleland: The incremental benefit from 3G for the incremental cost is probably going to be a real drag on 3G deployment.
As Bill mentioned earlier, there is not a killer high-bandwidth wireless application that people are itching to have.
Whyman: Looking at the business model on these things makes me even more concerned. You are talking about an
expensive transmission telecom subscription and another Internet service subscription. Are people going to be willing to
pay a third charge? There is talk about mobile advertising for mobile commerce, but that is just far out at this point.
Cleland, left, and Whyman: Alerting investors to a changed Washington.
Q: So who's promoting 3G?
Whyman: People point to Europe. But there it was state-nurtured and state- funded. And, for example, 1% or less of
Deutsche Telekom's wireless subscribers have Internet access. If you look at the advertising side, the total size of the
market in all Europe for advertising is less than $1 billion.
Q: What does this mean for NTT DoCoMo and its iMode, which is based on the 3G standard?
Cleland: We question whether or not that will transport well outside of Japan.
Q: Elaborate, please.
Whyman: DoCoMo's iMode is a completely different technical standard than what AT&T is using and certainly what is
being used in Europe with the GSM families. Like so many things, Japan is Japan specific. We are not saying iMode is
not great, but it is hard to transplant out of Japan, based on technical content, the regulatory protection that exists, and a
bunch of highly specific cultural factors that drive that market.
Q: What are your thoughts on cable here?
Cleland: The D.C. Circuit Court lifting the FCC's ownership limits recently was a very positive development for cable and
it could create an atmosphere of consolidation around the industry. That's a positive. Cable, however, has two big
problems: It doesn't know what its cable broadband business model is and it doesn't know what its legal classification for
regulatory purposes is. The cable industry knew it could make a ton of money if it kept totally closed, but for antitrust and
other political reasons the cable companies have to allow open access. The question for them is on what terms, and how
quickly they open up. The second big uncertainty cable faces is one of legal definition. Cable does not want to be
regulated at all for its next-generation services. It has avoided any regulatory classification so far. But there is a Supreme
Court case next year that is going to cause problems for cable in the sense the court may decide whether cable is really a
telecom common carrier, a less-regulated cable service or an unregulated information service. Those are big questions.
They are going to have to be answered in the year ahead. But make no mistake about it, this Administration and this FCC
can be expected to be quite cable friendly. So it's a positive outlook for cable with some very nagging concerns about how
they make money with broadband and how they eventually will be regulated, or not regulated.
Q: What areas in telecom are investors overlooking?
Cleland: Mexico's telecoms deserve a fresh look. Mexico has the fastest-growing and second-largest telecom market in
Latin America. The election of Vicente Fox and a landmark telecom regulatory settlement between Mexico's telecoms have
really changed the dynamic there for the positive from what used to be highly uncertain and highly problematic. They had
privatized but not organized themselves for the private market. Also, they settled some longstanding feuds between the
incumbent and the competitor last fall. And they strengthened the referee, which is Cofetel, the regulator.
Q: What are some names?
Cleland: Telmex is the incumbent and is 9%-owned by SBC. Avantel, 45%-owned by WorldCom. Alestra, 49%-owned by
AT&T. Axtel, about 27% owned by Bell Canada. Then there is Grupo Iusacell, which is one-third owned by Verizon, and
Vodafone announced in January it will acquire 34.5%, as well. There is also Pegaso, which is backed by Leap Wireless
and Sprint.
Q: What else should investors focus on globally?
Cleland: There are some other global stories that are important, but from a negative standpoint. One is the United
Kingdom, the country that started the whole telecom competitive deregulatory trend more than 20 years ago, is in the
middle of a 180-degree turn back towards heavy regulation.
Q: What's driving that?
Cleland: The Blair government is getting squeamish about deregulation and privatization. It is significant because the
world is following the U.K.'s lead. This is a very powerful early precursor for global telecom investors. Essentially, the
Blair government has a more regulatory philosophy than the Thatcher government that started all this. We are seeing
legislation being drafted that will create a much bigger bureaucracy with much greater powers to oversee the U.K. market.
All the signals we are seeing is it is not a deregulatory and not pro-competitive environment. It is going back to the old
style of heavy regulation.
Q: Didn't you just put out a report on "privacy" standards in Europe?
Cleland: Yes. We are suggesting that pan-regional privacy regulations in Europe may slow the rollout of location-based
applications. In the worst case, privacy regulations being considered in Europe could thwart development of software in
devices and networks, fragment the market, and hinder global growth of m-commerce. Use of personal data is the basis of
lots of location-based mobile-communications applications. So European providers like Vodafone, Nokia and T-Online
could be hurt by privacy standards that limit their ability to deploy location-based services. And it may be another setback
for 3G if location-based services are restricted. Also, a privacy directive by the U.K.'s Data Protection Commission
suggesting all advertising based on location and purchase tracking patterns be banned throughout the European Union if
adopted as a standard could wind up prohibiting software development and dumbing down technology for devices and
networks. This has negative implications for Alcatel, Nokia and Ericsson. U.S. mobile providers, in contrast, are required
by the FCC to incorporate location monitoring and reporting capability by the fourth quarter. And U.S. providers of
m-commerce services like Verizon, Motorola and AOL Time Warner could benefit from the flexibility of the U.S.'s
currently less rigid privacy standards.
Q: What else worries you on the international front?
Cleland: Many investors may be excited about the China market given that China is now entering the World Trade
Organization. We would caution people to be very careful because while China may have promised a lot on paper, they are
not doing the things necessary in their actions to make telecom investment in China a good deal.
Q: Thanks, Scott. Thanks, Bill.
=================== |
