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Transformation Interrupted - Part I: Surveying the Wreckage
(Please note: Originally published in July 2002, exhibits from this report can be seen in the downloadable .pdf copy)
I. Surveying the Wreckage
The Number You Have Reached Is Not In Service
By June 2002, over seven years after the Telecom Act of ’96, an expanding sinkhole had swallowed large chunks of the industry and triggered widespread restructuring, bankruptcy protection, or outright liquidation. Amongst publicly-traded new service providers alone, the count went from a peak of 43 to 12, accompanied by a 98% reduction in market capitalization (a loss of over $350 billion), and average enterprise values fell to 80% of the now severely discounted Plant, Property & Equipment (PP&E) assets alone. In other words, on average these surviving companies are still worth less than the diminished book value of the networks they own, as shown in Exhibit 1.
Even worse, the ethical gamesmanship that overtook some of corporate America in the ‘90s, and the particular desperation of the telecom industry, resulted in an additional $50 billion of formerly investment-grade debt sinking into junk or distressed status at Worldcom and Qwest. The collateral damage at equipment suppliers such as Lucent, Cisco, Nortel, Alcatel, and dozens of smaller infrastructure vendors conservatively included:
- $60 billion revenue decline from the 2000-2001 peak,
- $960 billion loss of (irrationally exuberant) market capitalization,
- $3+ billion temporary “gray market” of barely-used equipment and inventory backlogs,
- multiple multi-billion dollar write downs in ‘next generation’ (especially optical) technology investments, enthusiastically acquired with inflated equity as currency,
- and, much more poignantly, the global loss of several hundreds of thousands of jobs throughout the industry and across the pay scales, from the factory floor of outsourced manufacturers, to network engineers, to telecom investment bankers.
This Is Victory?!
The challengers may be vanquished, but you won’t find the incumbents at a victory party. Inter-exchange carriers (IXCs) like AT&T continue their losing battle against 20% annual declines in long-distance revenues.
Incumbent local exchange carriers (ILECs) face a largely negative mix of trends including
- Part 271 regulatory permission to offer in-region long-distance services resulting in as much as 20% market share in 9-12 months, but no more than a 30 basis point earnings contribution in the face of brutal price competition
- saturation of CLASS services (i.e. call-waiting, etc.), with revenue growth rates of these near-100%-margin features declining from almost 10% to less than 5%
- unprecedented actual (not just growth rate) declines in access minutes of use, and number of access lines, driven by wireless substitution and broadband penetration (i.e. more calls shifting to cellphones, disconnected second lines formerly used for faxes and internet dial-up access)
In the three quarters from mid-2001 to early 2002, a reduction in guidance for annualized revenue growth from 5-8%, to 3-5%, to 0-1%.
...incumbents, having successfully defended their local service monopolies from competitive incursion [are] drifting strategically and earning less than their cost capital.
In the same period, incumbent capital expenditure forecasts have been successively lowered by approximately $25 billion, to “maintenance” levels adequate only for repairing existing network assets, plus modest macro-demographic growth and expenditures required by regulation.
Most alarming of all, ILECs, the financially and strategically strongest branch of the incumbent family, as of the beginning of this year are delivering returns at or even below their weighted average cost of capital. As shown in the exhibits below, these results are a cause for concern, because despite a focus on cost-savings from merger synergies, ILEC operating expense reductions have failed to hold the line on cost per access line (Exhibit 2) , and productivity improvements have reached a plateau as well, as shown later in Exhibit 13.
No way out?
Recent signs, most notably the Worldcom debacle, don’t exactly point to a sector recovery. Daily news stories continue to feature incumbents announcing ever-reducing earnings, and once-powerful challengers’ networks sold for scrap at fire-sale. Visions of a new telecom industry are little more than a bad joke. The incumbents, having successfully defended their local service monopolies from competitive incursion, now too appear dead in the water, drifting strategically and earning less than their cost capital. Investors who have seen a quarter of a trillion dollars of cash disappear in this sector can be expected to think long and hard before committing more.
Indeed capital markets, trading the remaining telecom businesses below the value of their fixed assets, see no imminent recovery. What future then for telecommunications, and what can players and investors do to make money in this sector? We will argue in the following sections that, with different strategic thinking, the future is not bleak, that the revolution expected from deregulation and technological change is badly stalled, but not dead.
Restarting the transformation will require a new approach to telecommunications business development which not only offers the prospect of a return to top-line growth, but also a dramatically more efficient way to allocate capital. But before discussing growth strategies, we return to recent history and review what went wrong. ■
Download this article:: TransformationInterrupted.pdf [4.1mb]
11 July 02
