June 18, 2001
How the Fiber Barons Plunged
The U.S. Into a Telecom Glut
By REBECCA BLUMENSTEIN
Staff Reporter of THE WALL STREET JOURNAL
DENVER -- As he rushed to lace America with fiber-optic
cable, James Crowe wasn't the sort to let anything stand in his
way -- not the Rocky Mountains and certainly not his
crosstown rival, Joseph Nacchio.
By 1999, when Mr. Crowe's Level 3 Communications Inc.
started digging a line connecting Denver and Salt Lake City,
Mr. Nacchio's Qwest Communications International Inc. had
already threaded its own cable through the most direct route, a
seven-mile railway passage through the granite of the
Continental Divide. Undeterred, Level 3 swerved an extra 70
miles through southern Wyoming, installing fiber at a blistering
19-mile-per-day pace.
But now, Level 3 has hit a wall even Mr.
Crowe may have trouble overcoming. The
company's original ambition -- to build
history's largest, most advanced
fiber-optic network to carry exploding
amounts of Internet traffic -- is now part
of one of the biggest gluts the country has
ever seen.
All told, about 39 million miles of
fiber-optic cable stretch underneath U.S.
railroad beds, corn fields, natural-gas lines
and roads, enough to circle the earth 1,566 times. Companies
racing to build or expand nationwide networks laid some $90
billion of fiber during the past four years. Merrill Lynch & Co.
estimates that only 2.6% of the capacity is actually in use.
Much of it may remain dark forever.
The fiber glut underlies much of the uncertainty plaguing the
telecom sector -- and has even spilled over into the economy
at large. Billions of dollars in shareholder value have
evaporated in some of the biggest owners of fiber networks,
including Global Crossing Ltd., Williams Communications
Group Inc. and Genuity Inc. Many are struggling with massive
debt: On Friday, 360networks Inc. said it was delaying a
$10.9 million interest payment while it studies ways to
preserve cash (see article).
The carnage has spread to suppliers such as fiber-maker
Corning Inc. and Lucent Technologies Inc. Also on Friday,
Nortel Networks Corp., which makes gear for the Internet and
telecom sectors, predicted a staggering $19.2 billion loss for
the second quarter (see article).
Level 3, meanwhile, is fast
retrenching. Its stock is off
94% from its high, and
executives are expected
Monday to announce plans to
lay off as much as 20% of the
work force, among other
cost-cutting moves. The
company's game plan: live off
its stockpile of cash -- some of
it raised from Omaha
construction magnate Walter
Scott Jr., a close friend of
investor Warren Buffett --
until competitors die off and
demand returns.
"The shake-out that is occurring is good for Level 3 in the
long term, although it is awfully hard to convince someone
who is sitting in a dentist's chair being drilled that this is a
good thing," says Mr. Crowe. "It hurts."
Level 3's troubles represent an even bigger threat to the
economy than the first round of the dot-com meltdown
because the telecom companies involved are so much bigger.
As a group, telecoms have gorged on some $650 billion in
debt and are now failing in record numbers for the industry.
The debacle is shaping up to be one of the biggest financial
fiascoes ever, with losses to investors expected to approach
the $150 billion government cleanup of the savings-and-loan
industry a decade ago. And as more companies recognize the
depth of their problems, the damage is likely to get worse.
To understand the origins of the mess, it helps to take a close
look at two of the industry's pioneers, Qwest and Level 3.
Located just miles apart in the Rocky Mountain foothills, each
sprang from the ambitions of an old-style Western billionaire.
Each dazzled investors early on with visions of rapidly
expanding demand for telecommunications bandwidth, only to
run into difficulties when Internet usage didn't soar as
expected. But in the end, only one of the companies would
figure out a way to shelter itself against the coming storm.
It has been said that the fiber glut bears a striking resemblance
to the overbuilding of the railroads in the late 1800s. So
perhaps it's fitting that one of the first to launch a nationwide
network to compete with the long-distance companies was
Philip Anschutz, a Denver railroad and mining baron whose
net worth last year was put by Forbes Magazine at $18 billion.
By the mid-1990s, when Mr. Anschutz turned his attention to
the industry, most of the nation's fiber was owned by AT&T
Corp., Sprint Corp. and MCI, along with a few upstarts. The
hair-thin strands of superclear glass carry infrared light
generated by tiny lasers that blink on and off billions of times
per second, in a code that transmits voice calls or data traffic.
Fiber dramatically increased the number of calls that could be
handled at one time, making it far cheaper to use than coaxial
cable, which is made of copper wire encased in plastic and
aluminum.
Mr. Anschutz first became intrigued with the business through
his ownership of Southern Pacific Rail Corp., which had a
construction subsidiary that installed fiber along railroad tracks
for other customers. When he sold Southern Pacific to Union
Pacific Corp. in 1996, he retained the subsidiary, SP
Telecom.
Laying fiber isn't technically difficult. Networks are built by
burying plastic pipes, or conduits, in the ground and then
literally blowing the fibers through with compressed air. One
recurring problem is obtaining the right-of-way from property
owners. It was there that Mr. Anschutz seized on his
advantage: SP Telecom was already armed with the go-ahead
to build along much of the nation's railroad tracks. He decided
to build a newfangled network specifically designed to carry
increasing amounts of data traffic -- with the goal of renting
space to other telecommunications companies that needed
long-distance capacity. In industry lingo, he would become a
carrier's carrier.
Mr. Anschutz called the company Qwest
and in January 1997 hired Mr. Nacchio,
an engineer by training who was then
head of AT&T's huge consumer unit, to
bring it public. A compulsive workaholic
who once finished the New York City
marathon with a badly bleeding foot, the
51-year-old Mr. Nacchio left his family in
New Jersey and commuted to the Denver
headquarters, routinely working until 11 at
night.
When Mr. Nacchio took over Qwest, he immediately bumped
up the plan to build a 13,000-mile U.S. network to 18,500
miles. It looked like a financial stretch at first. Qwest had
$150 million in seed money from Mr. Anschutz, but the rest
came slowly. After a two-week road show in March 1997,
Mr. Nacchio secured $300 million in debt at a relatively stiff
11.875% interest rate. Three months later, Qwest went public,
raising $318 million.
But before long, business took off. As one of the first entrants
to the market, Qwest was able to reel in some early telecom
clients. GTE Corp., Frontier Corp. and WorldCom Inc.
bought about half the fibers on Qwest's network for about
$3.6 billion, enough to cover about 90% of the cost of
building its entire network. Within six months, Qwest's stock
price had doubled.
The success wasn't lost on one of Qwest's board members, a
telecom visionary in his own right named Jim Crowe. A
former WorldCom chairman, Mr. Crowe was fixed for life
financially and testing out retirement.
But he was growing antsy and wanted back in the game. He
had long toyed with the idea of setting up a long-distance fiber
network himself. And he had a billionaire of his own to back
him up: Mr. Scott, his former boss at Peter Kiewit & Sons,
the closely held Omaha construction giant.
Mr. Scott was receptive to the idea. At a 1995 gathering in
Ireland of executives close to Mr. Buffett, Mr. Scott had been
dazzled by a talk by Bill Gates. The Microsoft Corp. chairman
told the audience that the Internet "was radically going to
change the world," Mr. Scott recalls. And Mr. Crowe already
had a stellar track record: A few years earlier, he had built a
Kiewit telecom spin-off, MFS Communications, and sold it to
WorldCom for $14 billion.
So in 1997, Mr. Crowe told Mr. Anschutz that he was
planning to leave the Qwest board at the end of the year. "I
said that I might start a company and it might be competitive,"
says Mr. Crowe.
The move, when it came, caught Mr. Nacchio by surprise. He
says he knew Mr. Crowe was drumming up a plan but
believed he would focus on the local-phone business. "Jim
asked me, 'What is the best place to locate a company?' I said
Denver," says Mr. Nacchio. "I didn't know he was going to be
a direct competitor. If I'd known that, I would have said
Pennsylvania."
Mr. Crowe started Level 3 with $3 billion from Kiewit and a
select group of investors, including Mr. Scott, who became
Level 3's chairman. Instead of having an IPO, Level 3 simply
took over a tracking stock held by Kiewit and was listed on
the Nasdaq in April of 1998. He located the company in
Broomfield -- just 14 miles from Qwest's Denver
headquarters -- a spot Mr. Crowe says he picked after a
national study about where high-tech talent wanted to live.
The 51-year-old Mr. Crowe, an imposing figure who could
pass for a high-school football coach, started with plans for an
ambitious global network. He broke ground for a 16,000-mile
U.S. route in Schulenberg, Texas, in July 1998, and then drew
up plans for a 4,750-mile network in Europe. Tapping an
Omaha connection, Union Pacific head Richard Davidson,
Mr. Crowe got permission to build on the railroad's lines for
some of its routes. Before long, the company was working in
20 different time zones, with 250 crews digging at once in
North America alone.
The Sniping Begins
The sniping between Qwest and Level 3 started almost
immediately. A clearly hurt Mr. Nacchio groused that Mr.
Crowe was pursuing a "copycat strategy" and openly
wondered whether his rival had unfairly gained insights during
his time on the Qwest board. "At the end of the day, I have
always questioned why he would join," he says. "I'll bet you
he learned something being on our board."
Mr. Crowe, who insists he was up-front at all times with
Messrs. Anschutz and Nacchio, retorted that Level 3's
network would be a technological leap beyond Qwest's. Level
3's innovation was to lay 12 conduits in each leg of the
network, against Qwest's two. Only one might have any fiber
blown through it at first, with the rest to come as demand
warranted. Since one of the biggest costs in laying networks
was the digging, Level 3 figured it could save money in the
long run by doing it just once. It would also be able to adapt
quickly as new kinds of fiber became available.
"Qwest is a fine company and I like Joe. However, we have a
big disagreement," says Mr. Crowe. "Our goal is not simply to
deploy one generation but to build an entirely new model that
assumes technology will change quickly, and at times,
unpredictably."
Mr. Crowe quickly attracted an almost cult-like following with
his theories of how the Internet would revolutionize the stodgy
world of communications. One of his best-known principles,
and one of the main reasons he built such a large network,
was known as disruptive pricing -- using low prices to
stimulate Internet demand. "For every one percent you drop
price, you get a greater than one percent increase in demand,"
Mr. Crowe said again and again.
He also had little patience for vertically integrated companies
that try to do it all. Instead, he argued, communications would
eventually drift toward a high-tech model, where each of the
most successful companies carves out its own niche.
Investors ate it up, especially in Omaha, where the Peter
Kiewit name was legend. Generations of engineers had
already become wealthy through an employee stock
ownership plan, and when Level 3 was spun off, the workers'
paper profits soared. The fact that Mr. Scott sits on the board
of Berkshire Hathaway Inc., and Berkshire's legendary leader,
Mr. Buffett, keeps his offices on the 14th floor of Kiewit
Plaza, only added to the allure. "A lot of people thought this
was the next coming, the next Berkshire Hathaway. They
loaded all their assets in," says Marc LeFebvre, a stock broker
in the Omaha office of Dain Rauscher Inc. who, along with
his father, once worked at Kiewit.
By February 2001, Level 3 had managed to raise $13 billion,
enough to finance building its entire network and -- according
to its plans -- keep it going until it achieved profitability. Derek
Scarth, an equity analyst with Berger Funds, remembers Mr.
Crowe's pitch boiled down to this: "If you build it, they will
come."
But it wasn't customers who came so much as it was
competitors, lured by the easy availability of funding. J.P.
Morgan and McKinsey & Co. figure at least 50 companies,
offering a range of Internet backbone services, joined the gold
rush by the end of 2000.
"There was a time in 1998 and 1999 where we were getting
five offerings a week, just in telecom," says Brian Hayward,
head of telecom investing for Invesco Capital Management
Inc. The pile of prospectuses on his floor was two feet high.
Mr. Nacchio marvels at how easily the money flowed. In the
fall of 1998, he remembers coming up with a second round of
financing in a 10-minute call with bankers while driving to his
son's soccer game. "Before the game was over, we had
subscribed for a billion bucks at 8.9% interest," says Mr.
Nacchio. "To me, we had arrived."
Once the big dig was set in motion, it was hard for any one
player to scale back. Each had raised money by promising
investors a new fiber-optic network, and each felt compelled
to forge ahead to get revenue flowing as soon as possible. Mr.
Crowe, who watched competitors creep up behind him much
as he had crept up on Qwest, consoled himself with the
conviction that his network would be superior. And he and all
the others stood firm in the belief that Internet traffic --
whether e-mail, or pay-per-view movies or the frenetic
transactions of day traders -- would soon be gushing so fast
that it would engulf all their pipelines and more.
Major Miscalculations
In retrospect, the executives -- and Wall Street -- made some
major miscalculations. Too many companies focused on the
easy part of building a network: the long-distance loops that
cut mostly through rural areas. Too little money went into
widening the pipes that run into homes and offices, an
extremely expensive undertaking complicated by the fact that
the Baby Bells already own such "last-mile" connections. With
high-speed access slow to reach businesses and consumers,
development of the sort of "killer applications" that might spur
new usage dwindled.
Some analysts tried to sound a warning. In October 1998, an
Internet researcher at AT&T Labs named Andrew M.
Odlyzko published a paper debunking the widely held view
that Internet traffic was doubling every three months. Mr.
Odlyzko laid out an argument that in fact Internet use was
doubling only once a year. "It was an extremely convenient
myth," says Mr. Odlyzko. "Every entrepreneur who was
getting financing could quote it."
With the flood of investment money continuing unabated, few
in the business paid him any heed. But Mr. Nacchio was
starting to get rattled. With so many new entrants, he figured,
life as a carrier's carrier might get tough. The entire wholesale
market, Mr. Nacchio calculated, was roughly $9 billion a year.
"There wasn't enough revenue to go around," he says. So Mr.
Nacchio began converting Qwest into a retail company
instead, acquiring LCI Communications, which made Qwest
into the nation's fourth-largest long-distance company.
In June 1999, he dropped a bombshell by making a bid for U
S West, the Denver-based Baby Bell. Coming as it did in the
midst of America's Internet euphoria, the move stunned
investors, who wondered why Qwest would buy such a
traditional, slow-growing company. Mr. Nacchio even had
trouble persuading Mr. Anschutz that the move was justified.
"All I knew is that we were not going to succeed by being a
one-trick pony," says Mr. Nacchio.
Whatever the justification, the stock market wasn't buying it.
Qwest's shares plunged, but the $35 billion deal still went
through. Mr. Crowe, for the time being, was looking brilliant.
Level 3 stock surpassed $130 per share in March 2000.
Dangling fat stock options, Level 3 poached Qwest
employees, sometimes driving Mr. Nacchio to distraction.
Even though Level 3 was still more than a year away from
completing its network, it managed to grab headlines. In
October 1999, the company snagged a key piece of America
Online's business from WorldCom. Analysts estimated that
Level 3 undercut WorldCom's price by 50%. Mr. Crowe's
theory of disruptive pricing was having an impact.
But Mr. Nacchio had some disruptions of his own in mind.
Angered by the defections and worried about market share,
the executive ordered his sales teams not to lose any contracts
to competitors. The project, code-named "Operation Clean
Sweep," turned the tide back in Qwest's favor.
It also kicked off a deflationary spiral the likes of which few
industries have ever seen. In the wholesale market -- the
business of selling network space to other phone and Internet
companies -- prices are expected to plunge at least 60% this
year.
It's even worse for so-called dark fiber, which hasn't yet been
connected to the expensive electronic equipment needed to
make it usable. A major brokerage house, say, that wanted to
purchase its own strand of fiber could pick it up for $1,200 a
mile, down from as much as $5,000 in 1997, according to
Qwest.
Such sales are becoming increasingly rare, however, because
few companies are in a position to invest in the equipment
needed to connect the fiber into a network. That equipment,
including the ultra-fast switches called routers, costs many
times more than the fiber itself.
The pricing collapse, combined with the bursting of the
Internet bubble, has left the fiber industry gasping for air --
and Mr. Nacchio looking like a genius.
Saved by the Baby Bell
Thanks to the constant trickle of money from plain-vanilla
local phone service, Qwest is projecting revenue of as much
as $21.7 billion this year, up from $19 billion in 2000. It lost
$81 million last year and won't be profitable anytime soon, but
its stock price has been holding steady lately at around $33 on
the New York Stock Exchange. That's down 48% from its
high but still well above the initial offering price, adjusted for a
split, of $5.50.
Life isn't so easy for Mr. Crowe. After trading as high as $130
in March of last year, the company's stock closed Friday on
the Nasdaq Stock Market at $7.62, off 34 cents, or 4.3%. By
some estimates, investors in the Omaha area alone have
suffered paper losses of as much as $20 billion, leading to
plenty of grumbling around town.
Tom Dowd, an Omaha attorney, is kicking himself for not
selling his Level 3 shares earlier, but he still has faith the
situation will improve. "Walter Scott has his reputation on the
line with all these people getting it in the teeth," he says. "He
doesn't want his legacy to be a foul ball."
It will take some doing to turn Level 3 back into a hit. Due to
some environmental problems in California -- the digging was
disrupted temporarily by regulators when a trout turned up
dead near the route -- the network isn't quite finished. Of the
96 fibers in Level 3's first conduit, only two are currently lit.
And, despite winning high-profile customers such as Yahoo!
Inc. and XO Communications Inc., Level 3 recently lowered
its projection of communications revenue for this year to as
little as $1.4 billion from $1.7 billion. In 2000, the company
reported a net loss of $1.45 billion on revenue of $1.18 billion,
including $200 million in revenue from mining operations.
Some acquaintances have noticed that Mr. Crowe seems more
subdued these days. But in public the executive remains the
picture of confidence. He stresses that the company still has
$4 billion in cash and says it will emerge from the shakeout.
"A year ago we were in a hothouse environment where every
plant, regardless of its strength, prospered," he says. "Now,
we are outside in the cold world. It is a better environment, as
painful as it is."
Write to Rebecca Blumenstein at
rebecca.blumenstein@wsj.com |
