Good idea. I hope athm does not bleed too much more.
Just in case you did not see it, the Barron's Lead this week is a
round table on Telecoms:
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June 7, 1999
The Winners Are . . .
Our panel handicaps the race for dominance in global communications
Once upon a time, a telephone company basically was a monopoly that provided voice communication service into and out of a geographical region. Businesses and individuals alike had no choice of which provider to use.
Jump to the present. The free market rules. Competition is fierce at home and abroad, new technology is expanding the speed and content of what's delivered, and global consolidation, in the form of mergers and acquisitions, is accelerating. Fueling this frenzy are likely regulatory and accounting changes that could exacerbate global turf wars.
Why are deliverers of voice and data getting together with providers of content, especially cable TV and video? When the dust settles, how many giant companies will dominate this reconfigured industry? Two editors of Barron's recently put these and many other questions to a panel of experts. The trio:
Oscar A. Castro, a principal of Montgomery Asset Management, who runs the Montgomery Global Communications fund.
Marc J. Gabelli, a managing director of Gabelli Funds, who co-manages the Gabelli Global Telecommunications fund.
Jack B. Grubman, a managing director of Salomon Smith Barney, who heads the firm's global telecom team.
To pick their brains and discover their stock picks, read on.
-- Peter C. Du Bois
Barron's: What's the big picture here? Is the convergence of telecommunications, cable TV, the Internet, satellite transmission and interactive services really the wave of the future, or is it merely a big bandwidth pipe dream? The recent pace of mergers and alliances is just mind-boggling. Does it make sense anymore to invest in a plain old telephone company?
Grubman: Your question is a good synopsis. From my perspective, and I've been involved in telecoms for 22 years since I started at AT&T in the mid-'Seventies, I've never seen more anxiety on the part of corporate CEOs than I do today. Companies are trying to figure out how to align themselves in this new world order. My view of how the landscape will shape up is as follows:
Over the course of the next three or four years, there will be a stratified structure within this industry on a global basis. There will be four, five, six, maybe seven mega-carriers, not 20. These companies will have all aspects of the value chain covered, from the network to the bandwidth to the applications to distribution to connectivity. They will want to have scale and scope of facilities on a global basis. They will want ubiquity of distribution. They will want product sets and applications. If there is a killer application in global telecom, it's the ability to offer cross-border networking, data and Internet protocol solutions, to business customers.
In other words, you want to take a fat pipe out of a building in New York City and connect it to fat pipes in buildings around the world, on your own network. If you look at the calculus of value creation in telecom, it will be driven by those companies that can provide bandwidth-centric services.
Q: How big is this industry?
Grubman: Telecom is a trillion-dollar business worldwide, maybe a bit less. Half the bits that go across networks are data, but 90% of the revenues are voice. Over the next five years, 60%-plus of the growth in revenues will be data. So, if you're going to create superior value relative to your peers, you'd better be skewed toward being able to provide enhanced data services.
In order to do that, you must serve the larger business customers who drive a disproportionate amount of these types of services. To do that, you need to own and operate assets end-to-end, to have North American optical fiber, European fiber, Pacific Rim fiber, city networks in the top 150 or so cities around the world, some underseas cable and Internet protocol.
The truth of the matter is, owing to technology and public policy, borders don't exist anymore.
Q: Regulators do, though.
Grubman: True, but they're pushing public policy to open these borders. The reality is, if you're going to be one of the few mega-carriers, you need end-to-end capabilities around the world. Nobody was born that way. Every carrier grew up in a segregated world. France Telecom cared only about delivering services in France, and so forth and so on. Therefore, to your point about merger mania, yes, there's a massive asset grab going on, with 20-30 companies all hoping to be one of the five or six mega-carriers.
Gabelli: This asset grab will be accelerated by a critical upcoming change in U.S. accounting rules on mergers. I'll come to that.
Grubman: Look, you still can be a small, niche company like a CenturyTel, which serves U.S. rural areas, and do very well. But the big guys in this industry all are striving to be one of the surviving 800-pound gorillas. And the reality is, you must disrupt your financial model to do it. To be perfectly blunt, everybody wants to look like MCI WorldCom.
Q: Who are the other heavyweights in this contest?
Grubman: In one corner are the old guard, the AT&Ts, the Nippon Telegraph & Telephones, the Deutsche Telekoms, the British Telecoms, the U.S. Baby Bells. In the other corner are the new guys, the Global Crossings, the Qwests, the Level 3s, with turbocharged currencies, meaning stocks, that can be used in acquisitions, and aggressive managements that are willing to try to buy older companies. Ten years ago, even five years ago, this industry was segregated and myopically focused, country by country. Today it's becoming more global and certainly bandwidthcentric, to the point where ownership of end-to-end bandwidth will be the main factor driving equity values.
Q: Marc, how do you see the industry shaking out?
Gabelli: I'd like to step back a little bit further and look at the business in a broader context. One side of the equation is distribution, which is forcing mergers and acquisitions. That game has a deadline. FASB, the Financial Accounting Standards Board, has proposed to end pooling-of-interests mergers in January 2001. Poolings are vital to companies that are valued on reported earnings per share, as opposed to cash flow. Poolings eliminate the creation of goodwill, which must be amortized, thereby depressing the earnings of the combined entity. Meanwhile, this accounting change is creating a dream scenario for investment bankers, who have a real excuse to push clients to beat a deadline to make pooling deals, and we foresee a frenzy of M&A activity over the next 18 months.
Content is the other side of the equation. Demand for more and more voice and data and video is accelerating demand for more and more bandwidth. I think we're in the fourth inning of a long ball game that should play out over the next three to five years. This process is an accelerated convergence of distribution assets and content assets.
Currently, we're in a phase where data are the primary drivers of this demand, but the video is likely to play an increasingly important role. We see this in many recent mergers, including AT&T's 1998 purchase of Tele-Communications, and the trend is likely to proliferate.
If we step back further, where did all this really start? I'd say when the Berlin Wall came down in 1989. That began a period of deregulation, with free-market models springing up all over the world. Now we are in a period of open competition. The World Trade Organization provides some of the framework for regulators. Technology also helps this process. Technological advances are an equalizer, bundling values among different distribution assets. Cable now provides telecom services. Telephones now provide video services. Privatizations and open competition are all about end-to-end connectivity.
This gives customers what they want at the right price. It's similar to what we see in the music industry today, where several major players dominate the marketplace by offering customers end-to-end solutions with global scale and local reach. That's a theme we'll keep focusing on as we look at telecom, global scale and local reach.
Q: That's what businesses want. Where does this leave consumers?
Gabelli: They'll receive a sweep of services that will turn them into globally interactive couch potatoes. Individuals already can transact on the Internet. Currently, there are 70 million Internet users worldwide, of which 30 million are in the U.S. That total should grow to something like 400 million in 2002.
Q: Subscribers to Internet services?
Gabelli: That's right. E-commerce currently is a $30 billion business that's estimated to grow to $300 billion in 2002. A large portion of this tremendous growth will be fueled by domestic U.S. consumers. Many recent telecom-related deals are all about gaining access to consumers at home. As prices for services come down, demand increases.
Q: Is this a good time for investors to buy plain-Jane telephone companies as opposed to nascent media conglomerates?
Gabelli: Absolutely. In terms of the Baby Bells, this really is a U.S.-related question. RBOCs already are transforming themselves. With the likely approval later this year by the Federal Communications Commission of Rule 271, which will allow the Bells to offer long-distance service, their stock-market valuations should migrate upward. Currently, they trade at seven to nine times cash flow, against 15-20 times for cable-TV companies. That's a big disparity in valuations. Bell Atlantic recently traded at 60, or about seven times its $15 billion of EBIDTA [earnings before interest, depreciation, taxes and amortization]. If it trades at 10 times, which is in line with what cable guys expect, the stock price goes to 100. I think there are near-term opportunities in many RBOCs.
Grubman: Let me echo something that Marc said, and let's throw America Online into this mix. AOL's market cap per subscriber is about $15,000. Cable companies trade at $4,000-$5,000 per subscriber. If you look at local-telephone-company access lines, stripping out things like cellular and international services, they probably trade at $2,000 per subscriber. Now let's put AOL aside and think about that. The number of subscribers grows about 1%-2% a year, no different than local telephone lines overall and probably a little bit less than for residential phone lines. Revenues and EBITDA per telephone line certainly are equal to, if not greater than, cable. In both cases, cash-flow growth is kind of mid-single-digit. So why is it that a cable subscriber, who by the way is the same as a home with a telephone subscriber, is valued at 2.5 times what a telephone subscriber is? I think there's a huge disconnect here, no pun intended.
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Oscar A. Castro Stock Picks
Company Where Traded Recent Price
Esat Telecom NNM 39 3/8
Sprint PCS NYSE 46 3/4
Orange NNM 71 1/4
AT&T Canada NNM 56 7/8
Global TeleSystems NNM 76 7/8
Swisscom NYSE 36 5/8
C&W Optus Australia A$2.98
MCI WorldCom NNM 86 15/16
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Gabelli: No doubt there is a disparity in values. But cable has a broad-band profile that is more robust than what the current RBOC can offer. Also, we're looking at business models that say revenues through cable pipes from e-commerce, from video services, from data, the Internet, etc., accelerate somewhat faster than revenues of RBOCs. I think RBOCs have yet to prove themselves worth more than they are.
Grubman: Right.
Gabelli: That said, a disparity in valuations currently exists.
Grubman: Let me come back to the question about consumers. A lot of capital in the telecom industry is chasing business customers, and for good reasons. The business customer is scalable. Take Citigroup or any other big multinational corporation. Their telephone needs keep growing like weeds around the world. By contrast, there's a finite amount of demand from the consumer market. From a return-on-capital perspective, potential profits from serving the business market are much higher. Having said all that, remember that both cable and telephone companies have assets in the ground, optical fiber or wireline. So they might as well try to scale their services to ride that plant over time. One of the more interesting horse races is being run by AT&T. Mike Armstrong, the CEO, has placed one of the biggest two-way bets by providing a full suite of services to homes. So is AT&T a local phone company with a juiced-up copper plant? Or is it a cable company? Don't forget, cable networks were designed to be basically dumb one-way deliverers of information. Yes, they bring more bandwidth into a home than a telephone company does. But cable is nowhere near as smart as a telephone network.
Gabelli: It's getting smarter, though.
Grubman: It still will be an interesting horse race. Telephone companies could do something known as VDSL. If they bring fiber to within a few thousand feet of a home, they could put a couple of hundred TV channels together with four or five phone lines into that home, over phone lines. The Bells' problem has been that they are held hostage by their investors, who like steady earnings and dividends. If the Bells aggressively invested to push fiber closer to residences, I think they could leapfrog cable companies.
Gabelli: They could appease investors with tracking stocks, just like Global Crossing plans to do in its proposed acquisition of U S West. In that deal, two tracking stocks will be created, one for investors who want growth, the other for people who want income.
Grubman: That's what Sprint did with Sprint FON, a long-distance company, and Sprint PCS, a wireless operator. If you want to own both parts of Sprint, you have to buy both stocks.
Gabelli: When AT&T was forced to divest its seven Baby Bells in 1984, it was free to redeploy its earnings into a whole suite of services. Now it's gone farther afield, into cable.
Q: Oscar, what's your view of the big picture in telecommunications?
Castro: What Jack and Marc just discussed has one simple answer. Cable-TV valuations are based on additional content that can be sent through underused fiber pipelines, mainly to homes but also to businesses. Phone valuations are based on interactive voice-distribution networks. Now these two businesses are merging into bigger and faster interactive networks with more content. The real key here is to have an integrated solution to provide content to pipelines that you are building or buying. AT&T seems to have a much better strategy than many telecom players.
Now I want to comment on other points that have been raised. In addition to telecom and cable-TV companies getting together, technology companies are joining the party. For example, we have seen Microsoft say, in effect, "Guys, I have no idea how to provide customer service in your businesses. That's your strength. But I do have a way for you to do it more efficiently, and I will get into your businesses as well." So Microsoft is going out and buying telephone and cable-TV assets to grab some underused pipelines.
Q: It will, or it has?
Castro: It has.
Q: By buying minority stakes?
Castro: It has taken more than stakes. It has acquired controlling interests in some companies.
Q: Is that merely Microsoft's way to force their software onto these companies?
Castro: It could be. Again, software is part of the content that we need to be able to watch TV or use Excel spreadsheets. However, content isn't everything. As investors, we must sit down and ask ourselves: What are the risks in all these mergers and acquisitions, and all this incredible growth that we see?
Q: The main risk is that not all mergers work out.
Castro: That's one risk. It's called execution. But what about valuations? Companies like Global Crossing are using their currencies, meaning their stocks, which have sharply appreciated in price, to buy real assets before their currency decreases in value. The only way they can avoid a currency devaluation is to execute their game plan properly. That's where good management comes in. WorldCom, now MCI WorldCom, showed the world that buying assets isn't a bad thing to do. But WorldCom's management isn't necessarily replicable. You may not be able to match its quality easily.
Grubman: Oscar, as usual, cuts right through all the rhetoric to the salient point. At the end of the day, management counts. Guess what? Every telephone company and media company around the world buys the same type of equipment from the same type of store -- the same routers, the same switches, the same fiber, etc. It all comes down to one thing, management. If Bernie Ebbers hadn't run WorldCom over the past 10 years, I doubt it would be where it is today.
Before we get sidetracked on other issues, like picking stocks, we must talk about bandwidth.
Q: What about it?
Grubman: Increased demand for bandwidth is the biggest change that has occurred in telecommunications over the past three or four years. I'm an unabashed bull on bandwidth, and have been for a very, very long time. I say anyone who worries about a capacity glut is out of his mind, okay? The fact is that as we move from a desktop-centric world to a Webcentric world, bandwidth replaces microprocessors and memory capacity as the enabler of growth. I would argue that as more bandwidth gets deployed, more applications will follow.
Castro: If you pinpoint the issues that will keep broad-band in demand in telecommunications, what's really important is video. It requires five or six times more capacity than voice communication. We'll finally see widespread use of video telephones that we've been talking about for the past 10 years. We'll have them one of these days in America, where innovations are created very quickly and very smartly. Their rollout in Europe will be much slower because Europe is far behind us in deploying new technologies.
Grubman: There's an analogy here to the natural-gas industry, where you have gas gatherers and gas pipelines. Think about it. Ten years ago, the telecom industry was a bunch of monopoly voice-communication companies around the world. Today, gatherers of bits, or digits, are proliferating. You have 10,000 Internet-service providers globally, several thousand competing telephone companies, charged-up cable companies willing to offer all kinds of stuff. You have faster and smarter networking devices being developed in garages around the globe. As Oscar pointed out, you have broad-band distribution increasing capacity to end users, business or consumer, by a factor of 10, 20, even 100, in some cases. When you do that, there is natural elasticity. Give people a faster, fatter pipe into their home or office and -- guess what? -- they'll fill it. And as they fill it, it further increases the demand for bandwidth. I believe bandwidth is the enabler for what will be a big chunk of global economic growth in the 21st century.
Q: Jack mentioned thousands of companies competing to gather and distribute information. Will there ever be a Standard Oil Trust of communications, or a Steel Trust of communications? Will the business be clutched in a couple of big fists?
Gabelli: In a sense, it already is. For example, Time Warner is close to a $100 billion market-cap company that's fully integrated, with distribution and content. It lacks the scale of an AT&T, but consolidation already is occurring. In this context, bandwidth is only distribution/vertical integration. It gives end users what they want at efficient prices. Full integration is the next step in this process, and it's already under way. Power centers are developing. AT&T is a major catalyst on a global scale. As we've said, it comes down to the question of good managements executing their business plans profitably. At the same time, some not-so-good managements oversee great assets, and investors can earn good returns in their stocks in this period of consolidation.
Q: Where do alliances and joint ventures fit into this scenario?
Grubman: I've never been enthused about them. You must own and operate your own assets. Look at Japan. Within the space of 48 hours recently, AT&T and British Telecom jointly bought 30% of Japan Telecom, which competes with NTT. Next day, AT&T announced an alliance with NTT for systems integration that didn't include BTY. If you're a customer of AT&T, you must be rather confused.
Gabelli: The Japan Telecom deal was about bandwidth. It owns the pipes through which it competes with NTT. The other alliance wasn't about bandwidth.
Grubman: I much prefer WorldCom's strategy. It digs up streets and lays its own pipe.
Castro: In our portfolio, we own some pipes and some content. I believe that content will continue to be valued higher than distribution. That's why the RBOCs never will trade at multiples similar to those accorded cable-TV companies like Time Warner. AT&T likely will be valued somewhere in the middle.
Gabelli: In a static world, RBOCs don't have content. As I said, their opportunities will be clarified this year, probably in September or October. If per Rule 271 they're allowed to enter the long-distance derby, one could theorize that they might, in time, want to acquire satellite-TV companies, which provide video nationally.
Castro: A huge process has started, and is accelerating, but is nowhere near finished.
Q: Who will dominate the consumer market?
Grubman: That remains to be seen. Two pending mergers, Bell Atlantic/GTE and SBC/Ameritech, would be very aggressive in growing out national strategies. They understand the gauntlet that has been thrown down by AT&T in the consumer space. Coming back to something that Marc said, I believe that within 12 months, satellite-TV services will be fully integrated parts of consumer bundles sold by the Bells. They'll partner with the satellite guys. And if the Bells decide to spend big money on the consumer side, they could offer bundled packages of video, real-not fake-local telephone service and long-distance service, which is a commodity for everyone. This combination would be a tough one for AT&T, using cable TV, to challenge.
Q: Who will be the losers in this global race?
Gabelli: That's probably too strong a word. It's really a question of managements creating positive shareholder value versus superlative value. I think the U.S. underperformers will be companies that are too big to be small, or too small to be big. They'll either get run over by big guys, or nibbled at by small guys. To be blunt, U S West was in this camp until it agreed to merge with Global Crossing. In Europe, former state monopolies face strong challenges. I'm talking about the likes of Deutsche Telekom, Telecom Italia and France Telecom.
Castro: British Telecom is an exception. They're deploying more bandwidth than any other former state company.
Gabelli: Absolutely. BTY has a global outlook and has been operating in a competitive environment for some time. But TI and DT have problems. DT wanted to merge with TI, but Olivetti launched a hostile leveraged buyout and captured 51% of TI. I think Olivetti now needs a partner to assume some of the debt it took on in this LBO. I think TI still is up for grabs. Meanwhile, DT lost two ways. First, it angered France Telecom, one of its partners in the Global One alliance [Sprint is the other] by bidding for TI. Second, as part of the Olivetti/TI deal, Germany's Mannesmann, which is competing strongly with DT at home, purchased some telecom assets in Italy. DT now is strategically misaligned, and must solidify its position globally. Frankly, I think DT itself could be acquired. For example, both Bell Atlantic and SBC want a stronger European footprint.
Continued.... |
