Telecom's Wake Up Call

The industry could be headed for a downturn

Just about any place you look in the telecommunications industry these days, there are signs of trouble. The stocks of the Big Three long-distance companies are all down at least 40% for the year. The biggest local-phone companies--Verizon Communications, BellSouth, and SBC Communications--have seen their shares slide. And there's a bloodbath among the dozens of telecommunications upstarts that have been founded in the past few years. The stocks of Viatel Inc., RSL Communications Ltd., and several others have tumbled 75% or more since the beginning of the year. GST Telecommunications Inc., a Vancouver, (Wash.)-based provider of phone services in the Western U.S., had to auction off its assets in August after filing for bankruptcy protection.

What's going on? For the past three years, the telecommunications industry has been one of the economy's most promising sectors. In the wake of deregulation, companies have been pouring billions of dollars into new communications gear to deliver everything from telephone service over cable-TV networks to Internet access over mobile phones. Capital spending soared from $42 billion in 1996 to $82 billion in 1999. And it's likely to go higher: Analysts project telephone companies will invest more than $100 billion in their networks this year.

"WAY OVERCAPITALIZED." But now the evidence is growing that all that money isn't being well spent. While capital expenditures have soared 25.5% annually since 1996, telecommunications revenues have increased a modest 10.5% per year, to an expected $326.6 billion in 2000, according to Lehman Brothers Inc. The result is that for every dollar invested, telecommunications players are seeing less and less revenue produced. In 1998, there was 42 cents in new revenue for every $1 invested. This year, that's expected to fall to 34 cents, according to Lehman Bros. That has put the squeeze on profits: Return on assets for the industry has dropped steadily from 12.5% in 1996 to an expected 8.5% in 2000. "It looks like the sector is way overcapitalized," says analyst Blake Bath of Lehman, which issued the first detailed report on the situation in early September. "Spending has grown at absurdly fast levels relative to the revenues and profits produced by that spending," says Bath.

What telecom companies have been doing is betting on the future. With the boom of wireless and data services, many experts thought growth in the $300 billion-plus industry would accelerate to about 15% per year. That would mean an extra $50 billion or so in revenues each year for companies to divvy up. What if that acceleration doesn't materialize? What if it remains at the 10% that the sector has averaged in recent years? Certainly, there still will be winners in telecom, but some players will reel. Returns on investments would be below expectations, many stocks would continue to dip, and investors may even cut off funding to some telecommunications companies by declining to buy their debt and equity.

Eventually, if revenue growth keeps falling short of the high hopes, there are likely to be repercussions throughout the economy. For starters, it could become difficult for some of even the biggest telecom companies to keep digging into their pockets for the billions of dollars they need for new investments each year. Any significant drop-off in capital spending in 2001 or 2002 would first hit the makers of communications gear, a white-hot segment of the stock market right now. Nortel Networks, Lucent Technologies, Cisco Systems, and even highfliers like JDS Uniphase Corp. depend on the telephone companies for their livelihood.

COMING UP SHORT. More broadly, any trouble in telecom could end up crimping economic growth. In 1999, the telecom sector accounted for 16% of the capital expenditures of the Standard & Poor's 500-stock index, far and away the most for a single industry. Given that importance, any slowdown in capital spending by the phone companies would make it more difficult to sustain the rapid productivity gains that have powered the current expansion.

That's hardly a paranoid, worst-case scenario. Even today, the telecom industry's performance is beginning to come up short. Company after company, from AT&T and WorldCom to Sprint and Verizon, have admitted recently that they're not going to hit the financial targets they had anticipated. AT&T, for example, told analysts its revenues would increase by about 6% from last year's $63 billion, not the 8% to 9% rate it had previously expected. Even the growth segments of the industry, while doing well, are not quite living up to expectations. WorldCom Inc.'s Internet revenues increased 40% in the second quarter, to $1.2 billion, instead of the 45% analysts had been expecting. And both Verizon Communications and SBC Communications missed their initial targets for rolling out broadband Net connections, which could temper revenue growth.

Still, telecommunications players have little choice but to continue making the big capital bets for now. Because of severe price competition, revenues from the traditional long-distance and local voice businesses are expected to be stagnant over the next five years, at about $200 billion. At the same time, revenues from Internet and data services are projected to rise an average of 24% per year, to $150 billion in 2005, and wireless sales 20% per year, to $125 billion in 2005. In other words, the major telecommunications players need to keep investing heavily in these new services to have a shot at a high-growth future. "When you look at our capital spending, there's a clear correlation to our growth businesses: wireless and data," says Frederic V. Salerno, vice-chairman and chief financial officer at Verizon Communications, which is sinking $18 billion into capital expenditures this year, compared with $13 billion last year.

The situation is going to get worse before it gets better. Bath anticipates that the industry's capital spending will soar an astonishing 64% next year, to $173.3 billion, as companies bid on new wireless licenses being auctioned off by the Federal Communications Commission. That will drive down the revenue produced per dollar of capital investment 25%, to 26 cents, in 2001. And profits once again will probably be crunched.

Clearly, the situation isn't sustainable over the long term. If investors continue to see returns dropping in telecommunications, they're going to start moving their money into other, more promising industries. There's evidence this already is starting. The amount of money raised by telecommunications companies in debt and equity offerings tumbled to $894.5 million in August, down from an average of $7.6 billion per month in the rest of 2000, according to Thomson Financial Securities Data. Junk bond issues, which have helped finance many of the upstarts, shriveled to $324.6 million in August, compared with an average of $1.9 billion in the rest of 2000. "Some of our diversified-portfolio managers are throwing in the towel," says Brian Hayward, portfolio manager of the Invesco Telecommunications Fund and strong advocate for the sector. "They're trimming their holdings [in telecommunications] because they think it's just not a good place to be right now."

SCRAMBLING. With capital becoming harder to come by, the telecommunications industry is headed for a shakeout. Small players will likely be the first to get hit. Many were founded on the assumption that they could lose money for several years, but investors are showing less patience. GST Telecommunications was the first of these upstarts to go out of business. Now, other companies, including RSL Communications, ICG Communications, and e.spire Communications, are scrambling for new cash and may have to sell out soon, analysts say. "We think the tightening of access to capital will bring a wave of consolidation," says Clark E. McLeod, CEO of McLeodUSA Inc., which provides local and long-distance phone service, primarily in the Midwest. The stronger upstarts, such as Nextlink Communications Inc. and Allegiance Telecom Inc., are likely to acquire some of the weaker companies to get broader phone networks on the cheap.

The major telecom players should be able to continue their spending spree through next year. They're counting on using a favorite Wall Street trick: issuing tracking stock for one coveted piece of their businesses. For example, AT&T had an initial public offering for its wireless operation earlier this year and pulled in more than $10 billion. Verizon filed for an IPO for its wireless business and may raise as much as $15 billion. SBC is expected to follow suit later this year with an offering of the wireless operation jointly owned by it and BellSouth. That deal could raise an additional $15 billion. All told, the major telecommunications players are expected to reap an additional $60 billion or so through the end of 2001 by selling off stakes in wireless and Net operations. If the companies can convince investors to fork over that kind of dough, competition for customers will only intensify over the next year or so. "That's just going to throw fuel on the fire," says Bath.

Even the telecommunications industry's biggest names are going to have difficulty not getting singed in the years ahead. If industry growth continues to be modest with all that capital being poured into new networks, one or more of the largest telecommunications players will end up in big trouble. There simply won't be enough profits to go around. The losers will see net income shrivel and their stock prices slide--and they'll have to cut expenses. "Not everybody is going to be a winner," says analyst Brian Adamik of market researcher Yankee Group.

Which companies are most vulnerable? Those that depend on the rapidly deteriorating long-distance business. The list starts with AT&T, but it also includes Sprint, WorldCom, and smaller players like Global Crossing. The central problem is that prices are tumbling--down about 10% since 1997, according to Yankee Group. That contributed to an 8% decline in AT&T's consumer business revenues in the first half of this year, to $10 billion. And that price pressure isn't going to stop anytime soon. Lehman estimates that the long-distance market is going to shrink more than 4% annually, from $78 billion last year to $63 billion in 2004. "Their core businesses are deteriorating a lot faster than we expected," says Hayward.

Look for these companies to try to combine with others to gain economies of scale and shore up profits. AT&T already has discussed merging with British Telecommunications PLC. WorldCom and Sprint announced plans to merge last year, but the deal was blocked by regulators. Now, the two companies could end up being acquired by foreign telecom players or one of the Bells after the local companies are allowed to offer long distance in more of their states. "The one thing that can save an industry like this is consolidation, so that less money is invested," says Jeffrey Heil, director of equity investments at the Regents of the University of California.

By contrast, the giant local phone companies--SBC, Verizon, and BellSouth--look well positioned. Their local networks are costly and complicated to replicate, so they're facing relatively little competition. The local-phone giants "own the last mile, and that's an asset that won't be duplicated," says Invesco's Hayward. At the same time, they're demonstrating that they're capable of taking market share away from the long-distance companies. Verizon, for example, has swiped more than 1 million long-distance customers in New York, and SBC has grabbed more than 500,000 customers in Texas in just two months. What's more, all three of them generate loads of cash that will help them finance expansion into new, fast-growth services. Verizon, for example, is expected to have cash flow of $28 billion this year, more than either AT&T or WorldCom, according to analysts' estimates.

TURNING THE BATTLESHIP. Not that Bell companies are immune to competition. AT&T is rolling out local telephone service over the cable-television networks that it has acquired. It expects to pick up as many as 650,000 cable-telephony customers by the end of this year--not just for the additional revenues but also to cut into the cash flow of the local phone companies. And the upstarts that still have financing are aggressively pursuing lucrative business customers. "The incumbents are going to have the hardest time reacting," says Royce Holland, CEO of Allegiance Telecom, which provides local, long distance, and data services to corporations. "You can't turn that battleship quickly."

For the telecom industry, the freewheeling days are ending. "Companies made a lot of promises, and now it's time to pay the piper," says Robert C. Taylor Jr., CEO of Focal Communications Corp., which provides local and long-distance services to corporations. The cost for the telecom sector--and the rest of the economy--could be high.