What a difference a year makes
Financial Post - Canada, Jun 9, 2001
BY DAVID OLIVE, SENIOR WRITER
Seventeen months ago, Greg Maffei quit his plum job as chief financial officer at Microsoft Corp. to join the vanguard of entrepreneurs who were revolutionizing the telecom industry.
As chief executive of 360networks Inc., based in Vancouver, Mr. Maffei was building a criticial piece of the new high-speed telecommunications network. He quickly expanded the reach of his two-year-old company's fibre-optic pipelines, which carry signals in the form of light beams across glass fibres, from the United States and Canada into Europe and South America.
Now, however, his ambitious plan to create a truly global network with a 22,000-kilometre Pacific undersea link and connections to Japan, China and Taiwan is in jeopardy.
360networks is struggling to fund its projects, and yesterday its shares dropped below $1, jeopardizing the firm's Nasdaq listing. Like so many of the companies that joined the race to build components of the next-generation telecommunications industry, one that promised to deliver a galaxy of innovative services to phone, cable and Internet users, 360networks has discovered, too late, that its business model is imperfect.
Only a year ago, the world seemed to have an insatiable hunger for additional bandwidth, or transmission capacity, to carry data and Internet traffic that was doubling every few months, and to make a reality of such vaunted technologies as streaming video and secure financial transactions over the Internet. Meanwhile, deregulation of the U.S. and European telecommunications industries in the mid-1990s had already fuelled demand for more bandwidth from upstart carriers that were challenging the hegemony of former monopoly telephone companies on both sides of the Atlantic.
Mr. Maffei anticipated that with relative ease 360networks would be able to sign up enough telecommunications carriers, Internet service providers (ISPs) and multi-national corporations with their own internal data networks to cover the US$7-billion construction cost of his globe-girdling web of glass-fibre highways.
What 360networks didn't count on was that competitors with the same idea -- notably Level 3 Communications Inc., Williams Communications Group and Global Crossing Ltd. -- would create a glut of bandwidth. At least in the short term, there is a lot more bandwidth than customers willing to pay for it. More than 97% of the world's fibre-optic capacity is "dark," still waiting for customers to light it up with data and voice transmissions.
Coinciding with this overcapacity, of course, is the sudden loss of faith in all sectors of telecommunications among lenders and investors, who are now reluctant to fund the completion of 360networks' system. Mr. Maffei is in a classic bind. Without additional funding, his company can't offer customers a global service. And without customers, he's having enormous difficulty scaring up the last leg of financing to complete his network.
The same quandary faces the dozens of new local and long-distance carriers and ISPs that sprang up in recent years, all promising to shake up a staid telecommunications industry that was notorious for introducing new services at a leisurely pace, and where monopoly operators tended to stifle innovation. As telecommunications companies of various stripes loaded up with US$650-billion in debt over the past few years, the upstarts vowed to bring high-speed Internet access, universal wireless, local phone service over cable and television signals over phone lines to consumers who craved new services and a genuine choice in providers.
The past year's meltdown in tech stocks, and the humbling of telecommunications carriers and equipment suppliers such as Nortel Networks Corp., obscures just how completely that revolution has stalled. The upstarts' lack of real progress was evident well before it was reflected in the stock market, where investors finally realized the odds were stacked in favour of the incumbent former monopolies and against both fledgling insurgents and deep-pocketed firms that have tried to take them on.
The so-called tech wreck has cut a wide swath, to be sure. But it has picked its victims selectively. Dozens of upstart carriers such as PSINet Inc., Northpoint Communications Group and Winstar Communications Inc. have failed or are on the ropes. But once mighty long-distance players AT&T Corp., WorldCom Inc. and Sprint Corp. are also crippled by expansion-related debt, and each is now a rumoured takeover candidate.
Some of the established carriers are in trouble, too. Many of Europe's largest former monopoly telcos, including British Telecommunications PLC, France Telecom and Deutsche Telekom, collectively took on US$100-billion in debt to acquire wireless licenses in government auctions, and are now cutting staff, suspending dividends and selling assets to restore liquidity. In the wake of the carnage, some European governments decided this week to let licence holders share antennas and transmitters to cut costs.
But in North America, incumbent phone carriers, such as Canada's BCE Inc. and Telus Corp. and the former U.S. Baby Bells -- Verizon Communications Inc., SBC Communications Inc., BellSouth Corp. and Qwest Communications International Inc. -- are thriving. They will be among the few companies still standing as the industry goes through a painful shakeout that eliminates all but the strongest players.
The U.S. telcos, in particular, have acted against the spirit of deregulation, making access to their local networks difficult to obtain for rivals that proposed to compete for their customers. Largely shielded from competition in their core local markets, the Baby Bells are the only combatants in the telecommunications wars that can still boast healthy balance sheets. They have been insulated from the price wars in which newcomers have brought each other to their knees. It was a tremendous drop in long-distance charges that helped make the Internet possible. Yet in this era of lower prices for most telecommunications services, the price of local calls has actually risen 73% since 1984, roughly the rate of inflation, while prices in the combative long-distance arena have dropped 34% during that time. The other big controllers of local networks, the cable companies, have also succeeded in imposing small but steady increases in basic rates over the past decade. From the consumer's point of view, there has been no revolution at all in low-cost services.
The new entrants can be faulted for a business strategy that saw most of them target the same narrow group of customers. Most of the upstart carriers and network builders crowded into the market for corporate buyers of long-distance, Internet and wireless services, leaving relatively untouched the residential and small-business consumers who still make up most of the total market.
The incumbent carriers own most of those local customers by virtue of the difficulty of replicating the metropolitan networks that act as a fortress for the traditional phone companies. Building and maintaining a network with wires under every street and running up to every home and small business in a city or town is a prohibitively expensive proposition for new entrants. So the newcomers focused instead on building a proliferation of long-distance networks. These were assembled at a rapid pace by simply burying fibre-optic lines between cities along railway, highway and pipeline rights-of-way.
The incumbent phone carriers, meanwhile, quietly upgraded their existing local systems to offer the same Internet and wireless services as the upstarts, but supported by a far more stable revenue base. While most upstarts have yet to achieve profitability, and many do not yet even have revenue, the entrenched phone companies continue to pull in enormous cash flow from tens of millions of residential and small-business customers. And, at little or no cost, they have added such new services as call display, call forwarding and automated directory assistance, from which they draw still more revenue. The bulk of the traditional carriers' revenue is guaranteed by government-regulated rate schedules. There is no such floor under the revenue base of the new entrants, whose pricing power has been further sapped with the arrival of each new entrant desperate for market share.
And while the newcomers were spending themselves silly to build networks that often duplicated each other, the incumbents were carefully reducing their costs. To fund upgrading efforts to meet the competitive threat posed by the upstarts, the traditional carriers resorted to layoffs and other cost-cutting measures. The result has been a noticeable reduction in the quality of customer service at incumbent phone companies. The portion of customers who say they are dissatisfied with the quality of their local phone service in the United States has jumped from 10.5% in 1997 to 17% in 2000. Yet the Baby Bells' customers, like traditional banking consumers, prefer uneven service to the inconvenience of switching providers. By the middle of last year, just 17.5% of local lines for big corporate clients were handled by new carriers, and a scant 3.2% of residential and small-business consumers had defected to upstart providers.
The telecommunications bubble has been a bust in more ways that one. The obvious calamity is financial: Investors have taken a US$500-billion hit from the drop in telecommunications share values. Weak carriers are scrapping ambitious projects. And strong incumbents, no longer fearing the competitive threat from the cash-strapped newcomers, are cutting back on plans to roll out new wireless, Internet and other services. Equipment suppliers won't soon recover in this era of yard sales at bankrupt telecommunications players, where almost-new Sun servers, Cisco routers and Nortel switches are fetching less than 50 cents on the dollar.
But the bigger issue is the almost certain loss of productivity gains the information revolution was supposed to deliver, along with a bevy of new services to be enjoyed by consumers. By some estimates, telecommunications innovations have boosted office productivity by more than 5% a year since the mid-1990s, a big contributor to the economic boom of recent years. Some experts now say productivity will slip back to the anemic 1% to 2% annual increases of the 1970s and 1980s.
To be sure, traditional firms as varied as Royal Bank of Canada, Wal-Mart Stores Inc. and Boeing Co. are using advanced internal data networks and the Internet to reduce procurement costs and score impressive gains in inventory turnover. But as new and incumbent telecommunications players alike slash their payrolls and cut R&D and capital spending, many of the innovations that were touted as imminent realities only a year or two ago are receding on the horizon.
Consumers will have to wait for the "wireless Web" and videos on demand over the Internet, carried on digital subscriber lines (DSL) that were expected to soon link most homes to the Web. DSL, which provides high-speed Internet access on traditional copper wires, was supposed to overcome the bottleneck between long-distance fibre-optic superhighways and the so-called last mile of old-fashioned copper wires in metro areas.
But the incumbent telephone carriers have stalled the DSL rollout by charging independent ISPs steep rates for access to their customers, and they have also been slow to offer their own DSL services. The promise of digital video, Internet access and telephone services by cable modem has also been painfully slow, given the high cost of installing modems in millions of homes. In the United States, fewer than 10 million households, or just 9% of the total, can obtain phone service from their cable providers.
The usefulness of any network, including telephone and Internet, has been described by Metcalfe's Law as being equal to the square of the number of users. In other words, the network grows exponentially in value as more users are added. It was this promise of universal, low-cost communication that made the Internet proposition so tantalizing. But the online community is growing at a slower rate than was anticipated. The pace of low-cost broadband deployment is almost entirely in the hands of local network operators -- phone companies and cable firms. And, at least for now, their top priority isn't plugging everyone into the Internet. They are preoccupied with the less challenging goal of achieving quick revenue gains by simply adding more lucrative features such as caller ID and widening the array of specialty cable channels for which they can reap a carriage fee.
Do we have anything to show for the telecommunications blow-out?
Andrew Grove, the visionary cofounder of semiconductor maker Intel Corp., told Wired magazine recently that "What this incredible stock valuation craze did was draw untold billions of dollars into building the Internet infrastructure. Instead of it happening over 15 years, it happened over five, because of the gold rush mentality of all these investors who were trying to get in on it."
Not unreasonably, however, those investors finally grew skittish about invisible profits at dot-coms and upstart carriers and ISPs. Having now withdrawn their support, those brave bettors have starved the early vanguard of info-age pioneers, leaving the revolution in the hands of the same slow-moving incumbents that ran the industry in the bad old days of rotary phones and the 17-channel cable universe.
For now, a two-tier system is emerging in which deep-pocketed corporate clients are able both to continue building their sophisticated internal data networks and to command the attention of incumbent telecommunications providers in getting plugged into the larger wired world. For the average residential and small-business user, though, the next phase of the information revolution will be marked by continued rising tariffs for basic phone and cable service and by slow response times for repair of dead phone and fax lines, glitch-prone voice mail, and Internet connections that do not connect and provide slow-speed access when they do.
"Our issues are solvable," Greg Maffei said recently, claiming that his company's investment to date has already created a fibre-optic network of immense value in advancing the high-speed communications revolution. He is probably right about the substantial asset that 360networks has built. But like so many of the adventurous newcomers to the telecommunications sector, Mr. Maffei risks seeing his debt-burdened company's greatest promise realized by an old-fashioned telephone utility that stands ready to buy 360networks and its faltering peers after they've hit the wall.
After all the hype about the twenty- and thirtysomething entrepreneurs who were charging the ramparts of the stolid phone companies, it turns out the telecommunications world still belongs to its most risk-averse and least imaginative players.
CASUALTIES OF THE TELECOM BUST:
TELESYSTEMS INTERNATIONAL WIRELESS INC., controlled by Montreal financier Charles Sirois, has lost 91% of its value in the past year as its Western European wireless unit, Dolphin Telecom PLC, faces a possible default on its loans.
360NETWORKS INC., headed by former Microsoft executive Greg Maffei, slashed its 2001 revenue target by 50% and shelved plans for a 22,000-km Pacific undersea cable and a separate Asian network. The company, which is seeking $300-million in fresh capital, lost about 93% of its share value in the past year.
RICHARD LI, symbol of Asia's Internet boom and son of Hong Kong billionaire Li Ka-shing, stepped down as CEO of Internet firm Pacific Century Cyberworks. PCCW shares have dropped about 90% since the firm gained control of Hong Kong Telecom, and it is coping with price wars and a heavy debt burden.
VERIO INC. of Colorado, a planned foothold in the U.S. market for Japan's NTT Corp., recently reported staggering losses of US$777-million for calendar 2000 on revenue of just US$328-million, with losses expected to widen this year to US$1.29-billion. NTT is now criticized for paying US$5.5-billion to gain complete ownership of Verio at the height of the Internet boom last year.
CABLE & WIRELESS PLC, the British-based firm's profit margins were driven to 4.9% in the six months ended March 31 from 17.6% in the first half of 2000 because of an oversupply in data networks. The drop occurred when CEO Graham Wallace began to focus on providing data and Internet services for corporate clients. C&W shares have lost 63% of their value in the past year.
PSINET INC., a pioneer in providing Internet services to U.S. corporate customers, recently sought bankruptcy protection. The Ashburn, Va., company has not been able to service US$4.3-billion in debt, and failed to integrate the 74 smaller firms it has acquired in recent years.
NORTHPOINT COMMUNICATIONS GROUP INC., created only four years ago, filed for bankruptcy protection in January after it was unable to sign enough customers to cover its debt. A year ago, the San Francisco-based Internet service provider had a stock market value of US$2.1-billion.
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