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All Wired Up And Nowhere to Go
For over 250 years, the Dutch Tulip Craze and Britain’s South Sea Bubble held undisputed top rank among history’s many speculative investment bubbles. Not until the late 20th Century did another contender for such high bubble honors emerge: the technology fever of the late 1990s. Only now is the full cost of this speculative insanity, which was centered in the Internet and telecommunications fields, becoming apparent. Because telecom services are so important to the economy, both for customers and investors, it’s important to understand how this particular business got into huge trouble and how it’s likely to recover.
Where Has All The Money Gone?
Some $700 billion worth of equity and billions more in debt have essentially been wiped out as the telecommunications industry’s hot air balloon has plummeted to the ground. The peak equity market valuation in North America for new and existing telecommunications service providers in 2000 was $1.15 trillion. The current equity valuation of the surviving companies that have not gone bankrupt is $425 billion. Poof . . . up in smoke went $725 billion dollars!
But is that real money, or just artificial appreciation? Since $500 billion of new equity was issued to these companies during the 1995-2001 period (as shown in the chart above), tons of real money was lost. In addition, $300 billion in debt was issued to the same companies over that time. This debt is now trading for cents on the dollar and in many cases is the entire theoretical residual value of the enterprises whose equity is worthless. Meanwhile, new financing has dropped to zero.
The magnitude of these losses is clear, but their impact extends beyond just the stock and bond holders. This debacle far exceeds even the massive savings and loan collapse in the 1980s that cost U.S. taxpayers $200 billion and investors many billions more.
While the telecommunications industry is not “insured” and taxpayers will not pay directly for losses several times the size of the S&L collapse, there is also a huge indirect price being paid. One immediate impact is that 400,000 telecom workers were laid off in 2001, more than 20% of the large number of U.S. employee layoffs last year. Longer term, the pendulum will no doubt swing to under-investing in telecom equipment and services. That could hurt national competitiveness for a while as other nations forge ahead with technologically advanced investments.
So what did these companies do with the fresh $800 billion dollars of capital in six years? They spent half on new equipment thought necessary to keep up with accelerating demand for data transmission. Entire new global networks were built in anticipation of continued booming demand driven by the Internet explosion.
Another $250 billion sits on service provider balance sheets as “goodwill,” thanks to over-priced acquisitions. A large portion of these ephemeral assets are now being written off due to the new FASB accounting regulations requiring one-time write-offs of impaired goodwill (previous rules permitted amortizing those “costs” over many years). The result will be a belated puff of smoke. Finally, after spending something over $100 billion on expanding existing entities and establishing new businesses, just $20 billion of the original $800 billion remains as cash on the companies’ collective balance sheets today.
What caused the seemingly infinite telecom business opportunity, based on Internet/data traffic growth, to implode before our eyes? Clearly, it was not the slowing in data traffic growth from 400% per year to a still-rapid 50%. There were two culprits: 1) technology advances on the supply side that were too good, offset by advances on the demand side that lagged — together causing massive overcapacity and, 2) flawed deregulation that created too much competition and backfired.
Tech Juggernaut Hits (And Buries) Target
On the technology front, optical engineers simply outdid themselves. One breakthrough allowed for core network capacity expansion that, in the end, provided the world with too much, too fast. The technology “at fault” is DWDM, or dense wave division multiplexing, introduced in 1995. Simply put, this divides the light carried by a single strand of glass fiber into many discrete wave-lengths — so one strand, that in the past carried a single voice call, could now carry 100 to 200 calls or data equivalents. That boosted capacity by a frightening amount.
With Internet traffic growing at a spectacular 400% annually in the 1990s (as shown to the right above), regulators opened up the telecom service field to new entrants and the capital markets were more than willing to fund fantastic business plans. Companies such as Global Crossing, Williams Communications and Level 3 Communications, were born to build global telecom networks.
Established competitors, such as ATT and WorldCom, felt compelled to upgrade their systems in order to keep up with demand and with the lower cost structures of their new competitors (new equipment was much more efficient). But just like traditional commodity businesses, pricing dropped rapidly as each new entrant attempted to gain market share. Given a much lower cost structure (based on DWDM systems) new players were easily able to undercut incumbent long distance providers. Typically, in high-fixed-cost commodity industries pricing heads down towards marginal cost — something not anticipated in the new telecom business models.
At first there was talk of a differentiated product, but the reality was that moving a data bit from one place to another could not be differentiated. DWDM systems drove costs down from $1.00 per marginal bandwidth in 1995 to $0.01 in 2000. (See chart below.) Prices slid right along the same curve, resulting in profitless prosperity as interest costs from mountains of debt remained fixed.
Today Global Crossing’s “assets” in bankruptcy, according to its balance sheet, total $22 billion — including $8 billion of goodwill and $12 billion in plant, property, and equipment. The only interested buyer today is offering $1.3 billion for all those assets, fifteen cents on the dollar. Many other companies are in the same knockdown situation. This is because in most telecom markets, capacity utilization is very low (often down around 15%). For some time to come, only specific bottlenecks will need attention.
Overall, telecom service companies’ capital spending in North America dropped 13% in 2001 and is expected to decline 30% in 2002. Given that overcapacity is huge and that spending was wildly excessive over the past 5 years, it is safe to assume that either 2002 outlays will fall even more than 30% or that the downtrend will last another year or two before more spending is needed to meet actual demand. Outside the U.S., Europeans are experiencing similar but less dramatic indigestion in their telecom industry. The Asia/Pacific markets are in better shape for various country-specific reasons, but overall the foreign picture is not strong.
The Last Miserable Mile
Where technology has actually undershot its potential is at the access portion of the network, a.k.a. “the last mile” to the end user, from the telephone pole to the house or office. Laws of physics come into play here because the core long-distance network discussed earlier is based on optical technology which, given the DWDM breakthrough, has been doubling in capability every nine months. On the edge of the network, however, conversions from lightwaves to digital/electrical pulses (to travel over old-fashioned copper wire) are governed by semiconductor laws, a.k.a. “Moore’s Law.” Capabilities here double half as rapidly, every 18 months, as has been the case for microprocessors in personal computers.
Thus, the core of the network saw a phenomenal boost in capacity and drop in cost, but the last mile could not keep pace. It is still dealing with how to extend high bandwidth economically to the consumer, to permit rapid access to multi-media entertainment and other data-intensive Internet offerings. Businesses have paid up for this capability for years via so-called T1 lines and ISDN connections. Service providers charge $1000 per month for T1 lines and $500 per month for ISDN connections. But most ordinary consumers balk at paying even $50 a month for broadband capabilities! This is the crucial bottle-neck discussed in our May 25, 2001 Staff Letter, “The Last, And Longest Mile.”
The cost of equipment and installation to overcome this obstacle just does not support lower pricing for the last mile . . . yet. Eventually, Moore’s Law will catch up and that elusive cheap last mile solution will arrive. It may not be DSL (digital subscriber line) or cable broadband, but rather a fixed wireless solution, that wins the end game. When the fix is found, demand growth will reignite if appealing applications for broadband communication are available (which is likely, given the time lag in solving this last mile problem). Then, accelerated data growth will finally absorb the excess core network capacity.
Congress Got Into The Act
Equally at fault for the telecom bubble and subsequent bust was the much ballyhooed Telecom Act of 1996. This legislation was intended to open up both long distance and local networks to competition that, in theory, would drive prices down and be beneficial to the consumer. It did that with a vengeance.
Local network service providers (the regional Bells, or RBOCs, that had been spun out of AT&T) were forced by the act to share their end-customer access lines with new competitors. The RBOCs were paid a small fee per line by the new competitor (called a competitive local exchange carrier, or CLEC), who then offered a full range of services to the consumer over that rented line. Unfortunately, again, the business model was unsustainable since the costs of customer acquisition, equipment, and installation all proved to be too high — in an environment of plummeting prices.
The net result was a rapid rise and fall of the entire CLEC subsegment and a resolve on the part of the RBOCs to stymie broadband adoption until the regulations change. As we write, there is legislation in Congress to remove the local access-sharing requirement. In February, the House passed the Tauzin-Dingell Bill, which would reverse the line-sharing requirements on the RBOCs, but similar legislation is widely expected to fail in the Senate.
While it appears that a reversal of the line-sharing mandate would give monopoly power back to the RBOCs, it can be argued that the main competition for broadband access will come from the cable companies who offer broadband speeds on their present lines, through cable modems.
Cable companies have virtually no direct cable competitors within their respective markets. They are legal monopolies and that offers them an advantage relative to the RBOCs, which have to share access lines with CLECs (if any remain in business). Cable companies have wired nearly their entire customer base with broadband capability and have captured two-thirds of the cable customers that have chosen a broadband service so far. However, the growth in subscribers for either broadband access method has been far, far slower than originally expected. Ease of installation has to improve and clearly a big reduction in monthly rates is needed to stimulate consumer interest.
Until Moore’s law finally produces equipment that is cheap enough to appeal to potential broadband customers, all the legislative changes in the world will not help. Subsidies, which are probably not likely, would be beneficial. They have been a big stimulus in Korea, where broadband penetration is well over 50% of the available market, while in the U.S. we are stuck at 10% for cable and DSL access combined.
Real Returns Or More Optical Illusion?
To restore health to the telecom business, consolidation in the core network needs to happen and excess capacity must be absorbed. Unfortunately, this will take time. When a few rational players remain and profitable business models are in place, reasonable returns on capital should follow. This may take years, though, as bankruptcy filings are just beginning and they will continue to disrupt the economics for all involved. Mergers have not even begun, as public market valuations have not yet stabilized.
Capital spending will continue under great pressure until excess capacity is completely absorbed. A reasonable estimate to reach that equilibrium point would be 2004. Meanwhile, the same carnage can be found, and will continue, among the many once-exciting companies that developed the advanced equipment for all portions of the telecommunications network: the switches, routers, fiber optic cables, optical multiplexers, etc. Optimism was wild here, too, and capital was flooding in, creating many new companies with more hope than substance.
Today, most leading-edge equipment makers are trading at just one times the cash on their balance sheets, not the ten or more times sales multiples that were common 2-3 years ago. Consolidation activity has begun for the newer, smaller equipment makers as customer orders have dried up completely and huge operating deficits have developed.
Established equipment providers that have sold equipment to AT&T and the Bells for decades (Lucent, Nortel, Alcatel), are suffering as well. They are far from the financial shape needed to step up as buyers of the smaller entities. Again, time will repair some damaged companies, while simple cash burn will drive others out of business.
Conclusion
As far as we know, Sir Isaac Newton (1642-1727) knew nothing about investing, but his famous laws of motion have periodically intrigued perceptive investors. Certainly law number 3 – for every action there is an equal and opposite reaction — applies remarkably well to speculative bubbles. There are also some specific lessons from the latest megabubble, in telecom, that are quite simple and useful: (1) deregulation can have significant downside for an industry, aside from benefits for its consumers (investors in airlines and truckers know this, too); (2) any business must generate an adequate return on invested capital — if not, survival is impossible; (3) breakthrough technological improvements can sometimes be hazardous to your bottom line!
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