Barron's
MONDAY, JUNE 21, 2004
Telecom Death Match
Fierce competition will claim more victims, says industry's Dr. Doom
By a Barron's Staff Reporter
IF YOU THOUGHT the communications business was brutally competitive, the Darwinian winnowing is just getting started. As the telephone, cable and satellite companies elbow their way into one another's turf, prices will decline and companies will fail to meet their growth targets.
Welcome to the world of Susan Kalla, a senior telecom analyst at Friedman Billings Ramsey Group, whom we dubbed Dr. Doom three years ago ("Sell, She Said," March 12, 2001).
She earned that moniker by slapping Underperform ratings on the telecom-equipment stocks she covered, a shocking move in the era before Sell recommendations came into vogue. Kalla came to her conclusion by polling the service providers to determine their demand for telecom equipment instead of heeding the rosy forecasts of CEOs. Investors who heeded those warnings were spared the agony of watching the equipment providers' stocks shrivel to single digits.
Table: As the Competition Grows ...
Now she has broadened her scope to the entire communications industry -- telecommunications, cable and satellite -- and concluded that revenues will rise by less than 1% annually, to $274 billion by 2006. That's far from the 4% annual growth the industry is promising.
The $17 billion shortfall means the industry has committed to too much capital spending and its bottom line will suffer. Shares of telecom players could fall 15% annually as competition heats up. The cable companies, which have higher debt levels and trade at loftier multiples, could face even greater risk.
"Everyone knows there's going to be a war, but they don't know the war is going to be this bad," she states.
The cable and telecom markets, once clearly defined and with high barriers to entry, have started to merge into one giant, commoditized market. Regulatory hurdles have fallen in tandem with the price of equipment. So instead of having six competitors in the cable market and six competitors in telecom, there will be 12 companies going head to head. And each competitor will offer the same package of video, Internet and telecom services. "Bundle is a euphemism for discount," she warns.
Kalla usually covers telecom-equipment companies and service providers. But after a breakfast a few months ago with former cable honcho Leo Hindery, Kalla took away Hindery's prediction that so many companies wanted to grab a piece of the communications pie that there wouldn't be enough business to go around. The result: prices would plummet, returns on invested capital wouldn't meet expectations and earnings growth would be elusive.
"You're on the eve of aggressive bundling practices," says Hindery, who was once president of TCI and later headed Global Crossing. "It will be a period of almost mutually assured destruction."
Kalla set out to see if the numbers backed up Hindery's gloomy scenario. Unlike most analysts who stick to one corner of the communications world, she decided to evaluate the entire industry. Some of her estimates were founded upon conversations with corporate buyers of telecom services. Others were based on talks with industry executives and company information.
She concluded that all the companies are trying to defend their existing turf by offering new services. The problem: The new services are being offered to existing customers at sharp discounts that don't provide a return on capital.
Some results: Revenues in the long-distance market will fall by 8% to 10%. The same is true for the local telephone business even after digital-subscriber- line revenues are included. Growth in cable sales, including Internet services, will slow to a 6% range and wireless revenue growth will slow from the teens to 7% to 8%.
The rub is that while revenues wither, telecom and cable companies remain saddled with the fixed costs of their investments, which were made on the basis of overly optimistic forecasts and cheap capital being thrown at the industry.
Cable companies recognize that their core television business is under attack from the satellite companies, which typically offer lower prices or more channels. Cable's share of U.S. households has shrunk to 72% from 83% over the past four years, while satellite's market share has practically doubled to 24% from 13%.
Competition should only increase now that the Bells have struck deals to resell satellite services to existing Bell customers. SBC Communications has a deal with EchoStar Communications' Dish Network while Verizon Communications and BellSouth have deals to resell DirecTV. That strategy of bundling DSL with satellite TV trumps cable's main advantage over satellite -- broadband Internet access.
The cable companies have tried to grow by offering customers voice-over-Internet-protocol telephony at bargain-basement prices. To do so they've spent $63 billion to upgrade their systems to handle voice and data, and they'll have to spend even more to develop billing systems and the like. The problem: They're entering a rapidly shrinking market. An increasing number of customers are giving up their telephones in favor of wireless phones. Wireless revenues of $86 billion exceeded local telecom revenues of $83 billion for the first time last year. Conversely, telephone companies are watching the number of local access lines decline every quarter. They're trying to hold the line on their local phone business, but are practically giving their customers DSL. Earlier this year, some of the Bells slashed the price of a DSL line to $30 from $50; as a result, DSL doesn't generate cash flow. But the move achieved its goal: Sales of DSL lines picked up and the growth in cable modems slowed.
"You can tell they don't want to bring down the price of local phone service so DSL just becomes a freebie," says Kalla. Now it's just a question of time before the cable companies decide to match the discounts, continuing the downward spiral.
The Bells also are trying to poach on the cable operators' core business. They're laying fiber lines that can carry video, a slow and costly effort. Verizon hopes to persuade households that normally spend $160 a month on voice, video and data to buy the same services from Verizon for $110 a month.
Kalla downgraded the entire telecom services group to Market Perform from Outperform in May after the group rallied off its lows of the fall. Verizon, the company with the most wireless exposure, is probably the best positioned of the Bells to enter this competitive world. And the Bells, in general, are in a better position than the cable companies because of their cash flow and lower debt ratios.
By 2006, the telcos should still generate $9.8 billion of free cash flow compared with the $1.2 billion from the cable companies. And the telcos will cover their interest expense by 4.5 times, versus the cable companies' much slimmer 1.3 times coverage ratio.
So while Kalla isn't crazy about the Bells, she thinks they're still better positioned than the cable companies. That's Dr. Doom's gloomy prognosis. |
