Telecom Meltdown

Profits are vanishing. Companies are going belly-up. And this industry's troubles just might flatten the economy

Last year, Sycamore Networks Inc. (SCMR ) was white-hot, with a soaring stock price and booming sales as telecom players scooped up its cutting-edge communications equipment. But on Apr. 5, CEO Daniel Smith told Wall Street analysts that his largest customer, Williams Communications Group Inc. (WCG ), and other telephone companies were slashing their spending. Smith said the company's sales for the current quarter would be only $50 million to $60 million, about $100 million less than analysts expected. "This is shaping up to be a very difficult and disappointing quarter," he said. The next day, the company's stock plummeted 20%, to $7.25--a far cry from its 52-week high of $172.50. Worse, Sycamore's troubles will trickle throughout its hometown of Chelmsford, Mass., about 25 miles northwest of Boston. The company will lay off 140 of its 1,100 employees, cut back its spending, and delay construction on a new corporate campus in nearby Tyngsboro.

Sycamore is just one example of how the meltdown in the telecom industry is rippling through the economy. Just five years ago, the opportunities for telephone companies looked limitless as deregulation in the U.S. and Europe opened up markets to competition and demand exploded for new Internet and wireless services. Established players began spending wildly on networks that would carry voice and data, while upstarts emerged, offering high-speed lines at low prices. Now, what once looked like the land of promise is quickly turning into a wasteland, as profits vanish, revenues slump, stocks plummet, and companies begin going belly-up.

As it turns out, too many players were chasing too little business. Brutal price competition set in, hammering profits, particularly at long-distance companies in the U.S. European phone companies went so far into hock for new wireless licenses that they're now scrambling to sell off assets to pay for them. Seven American upstarts have filed for bankruptcy, and dozens more are expected. And the industry's debt looks like a ticking time bomb: Telecom players in the U.S. and Europe have nearly $700 billion of it, and some analysts estimate that more than $100 billion in junk bonds will end up in default or restructured. Ultimately, the telecom meltdown could be almost as costly as the $150 billion taxpayer bailout of the savings and loan industry in the late 1980s. "It has been really ugly, and it could get a lot worse," says Austan D. Goolsbee, an associate professor of economics at the University of Chicago.

The fallout will be felt far beyond the borders of telecom, potentially crippling the U.S. and European economies. The telecom industry plays such a big role in economic growth that its troubles could wind up toppling other industries like dominoes. Already, fears about the health of communications-equipment makers have grown so thick that bankruptcy rumors swirl around Lucent Technologies Inc. (LU ) and Motorola Inc. (MOT ) Both companies deny them. And that's just the start. Nearly every technology sector is linked with telecom: Phone companies buy networking equipment to route Internet traffic, computer servers to offer Web hosting, software to dish up services, and fiber-optic gear to transport bits of information. Last year, spending on communications gear in the U.S. totaled $124 billion, or 12% of business spending on equipment and software, according to the Commerce Dept. Moreover, it accounted for one-quarter of the rise in business spending. Now, after boosting their spending 25% per year since 1996, U.S. telecom companies are slashing it.

The size of the spending cuts will affect the severity and length of the economic downturn, perhaps even causing a recession. Late last year, many Wall Street analysts were projecting that capital expenditures by U.S. players would be flat to down 5% in 2001, which would have triggered a mild, short-lived setback. Now, with the bankruptcies of some and the financial troubles of others, telecom companies are paring back more than expected. Spending is likely to drop 10% to 15% this year and stay flat in 2002. There's even a chance that expenditures will plunge as much as 25% this year. "This is how you get recessions," says David Wyss, chief economist at Standard & Poor's.

DOMINO EFFECT? Compounding the problems, the health of some financial institutions could be threatened as telecom companies continue to default on their loans. At best, the banks, insurance companies, and mutual funds that are owed that money will see their profits clipped in the months ahead. Bank One Corp. (ONE ) warned on Mar. 27 that its commercial loan losses would double, to $1.2 billion, in part because of its telecom exposure. At worst, widespread defaults could wipe out financial institutions with large exposure, much the way the oil industry's collapse in the 1980s battered money-center banks and crushed dozens of banks in Texas. In a Mar. 21 report, the Federal Deposit Insurance Corp. wrote that "cash-hungry telecom firms may have difficulty obtaining financing" and there could be "a serious risk for banks with a significant exposure to telecom startups." The Bank of England, Britain's central bank, has warned twice that the rising debt of telecom companies worldwide may cause instability in the financial markets.

To be sure, the telecom sector is just one part of the economic picture. If spending by other businesses and consumers remains strong, the economy may be able to avoid the two quarters of decline that define a recession. But if the rest of the economy is weakened by other factors, telecom's troubles could flatten it. Already, some parts of the economy look shaky. Other industries are cutting back on spending, too. And the consumers who have kept the U.S. economy chugging along may start shelling out a lot less because of rising layoffs and steep losses in the stock market. "With the stock market having dropped off, they're going to have to slow their spending," predicts Peter Hooper, chief U.S. economist at Deutsche Bank.

The sorry state of the industry will have a profound impact on the landscape of telecom for years to come. In Europe, British Telecom (BTY ), France Télécom (FTE ), Deutsche Telekom (DT ), and KPN (KPN ) went so far into debt for new wireless licenses that they may need to find merger partners to be able to afford the construction costs of the new networks. In the U.S., AT&T (T ), WorldCom (WCOM ), and Sprint (FON ) are so weakened that they may soon become takeover targets. At a Mar. 28 Morgan Stanley & Co. conference, WorldCom Inc. CEO Bernard J. Ebbers joked that the top execs from the Big Three long-distance companies and from local carriers Verizon (VZ ), SBC (SBC ), and BellSouth (BLS ) should meet in one room and figure out who should merge with whom. "Let them pick partners," he said.

All this has regulators a bit queasy. With more consolidation among the giants and less capital available for newcomers, there will be far less competition in some segments of the industry. Business customers, for example, won't see as many companies pounding on their doors with offers of cheap local telephone service. Several experts worry that the Baby Bells, especially SBC Communications Inc. and Verizon Communications, could wind up controlling virtually all of the consumer market and the vast majority of the business market. "God knows America is not getting the competition promised under the Telecom Act," says William Kennard, the former Federal Communications Commission chairman.

Telecom's troubles even threaten the spread of the Internet. Some upstart providers of broadband Net connections are so financially strapped that they can't expand as quickly as they had once hoped. Covad Communications Group (COVD ), for one, is planning to deploy no more than 190,000 new high-speed Internet lines this year, compared with previous plans for 380,000. Without a mass audience tapped into the Net at broadband speeds, the entire food chain depending on the growth of the Web could be hurt. Content companies could backtrack, software developers flee, advertisers return to television, and individuals who may have been drawn to the Net with promises of TV-like experiences could leave disappointed and not return. "I am really concerned," says Alan Ramadan, chairman of Quokka Sports Inc., which provides online coverage of everything from mountain climbing to the Olympics. "Anything that slows down consumer adoption puts an industry in formation at risk."

SIMPLE MATH. Not all of telecom, however, is on the ropes. The local phone companies--SBC, Verizon, BellSouth, and Qwest (Q )--have continued to turn in steady financial results, in part because they face relatively little competition in their core markets. At the same time, they've been able to capitalize on some of the fast-growing segments of the industry, such as data and wireless services. Verizon thinks the communications business is promising enough that it's boosting its capital spending to $18 billion this year from $17.6 billion in 2000. "We're going through a period where the fittest and the best-financed will do well," says co-CEO Ivan Seidenberg.

To understand how telecom got into this jam, turn back the clock to 1996. The U.S. passed the landmark Telecom Reform Act that year to deregulate the industry. And European countries, led by Britain, were opening up their markets to competition. The stakes were huge. Telecom revenues on both continents totaled nearly $300 billion, and the markets were growing about 10% each year.

The model for how to make a fortune in the new world of telecom was set by one oft-forgotten telephone company: MFS Communications Co. Led by James Q. Crowe, MFS laid telephone lines around major cities that would allow long-distance companies to bypass the Baby Bells. By the time the Reform Act passed in 1996, MFS had networks in most of the big cities in the U.S., and WorldCom agreed to buy the company for a staggering $14 billion, only slightly less than what SBC had paid for Baby Bell Pacific Telesis Group earlier that year. What WorldCom was paying for was not an operating business but strategic assets that would save it hundreds of millions of dollars it otherwise would have paid the Bells to deliver calls. The figure that stuck out for every would-be telecom entrepreneur was that WorldCom paid more than six times the value of the assets MFS had put in the ground.

The math was simple. You didn't need to build a business. You just needed to raise money, put telephone lines in the ground, and you could make a bundle. Some giant would pay you a multiple of every dollar you invested. The MFS model seemed to work for the next couple of years. In 1997, WorldCom bought another competitive upstart called Brooks Fiber for about $7 billion, or nine times the company's assets in the ground--the property, plant, and equipment.

When Net mania hit in the late 1990s and data traffic started doubling every few months, the telecom buildout became a free-for-all. Companies such as XO Communications (XOXO ) and Focal Communications (FCOM ) sprang up to build local telephone networks throughout the U.S. RSL Communications (RSLCF ) and Viatel Inc. (VYTL ) started building telecom systems in Europe. Global Crossing (GX ), Flag Telecom (FTHL ), and others started stringing fiber-optic cables through the world's oceans to carry the booming data and voice traffic. At the same time, megacarriers were investing heavily: WorldCom, for example, was building its own metropolitan phone networks from Stockholm to Madrid. All told, telecom players worldwide have raised $650 billion in debt and equity since 1996, according to Thomson Financial Securities Data.

In their rush, many execs built less-than-steady foundations for their companies. Rather than sell stock, they found the quickest way to get capital was to issue junk bonds. "It was high-yield heroin," says Royce J. Holland, former president of MFS and now CEO of Allegiance Telecom Inc. (ALGX ), which provides voice and data services to businesses. "You didn't need to do a road show with investors. You just had a conference call and you could get a few hundred million bucks." While having debt equal to a company's equity value is reasonably healthy, telecom upstarts took on debt that was 5, 10, or even 20 times their equity. They figured the more they could invest, the higher the price a giant would pay for their company.

Last year, the signs of trouble began. With so many networks being built on both sides of the Atlantic, prices started to tumble. Howard Jonas, CEO of international phone company IDT Corp. (IDT ), estimates that an STM-1--a phone line that can carry 576 conversations at once--between the U.S. and Britain costs $1.8 million today, down 85% from $12 million in 1999. "Prices have gone through the floor," says Jonas. Why? The economics of telecom are very similar to those for the railroad industry: Once you sink the money into the ground, it costs almost nothing to provide the service. "If there's a glut, it's going to be brutal," says the University of Chicago's Goolsbee.

Telecom just didn't turn out to be the fast-growth business executives had banked on. The number of bits transmitted and the number of minutes on the phone are rising rapidly, but severe price drops have meant overall revenue growth is modest. As U.S. telecom players boosted their capital spending by some 25%, their revenue growth was stuck at about 10%. That squashed profits. The return on equity dropped from 13.8% in 1996 to 5.9% last year, according to Lehman Bros Inc.

Company after company has missed its financial targets, stocks have plunged, and burned investors have slammed the capital markets shut. U.S. telecom players that pulled in an average of $2 billion a month in initial public offerings over the past two years raised a measly $76 million in IPOs in March. On Mar. 15, the highly leveraged wireless service provider Nextel Communications Inc. had to yank the IPO of its international arm. France Télécom had such a disappointing stock offering for its Orange wireless unit in February that it raised half of the $13 billion it had expected.

The troubles in telecom are being felt on both sides of the Atlantic. Wireless giant Motorola is cutting 22,000 jobs, and Sweden's phone maker Ericsson (ERICY ) says it may lose as much as $500 million in the current quarter. Telecom-equipment makers Cisco Systems (CSCO ), Nortel Networks (NT ), and JDS Uniphase (JDSU ) have missed their financial projections and started laying off workers. On Mar. 19, Solectron Corp. (SLR ) CEO Koichi Nishimura said the contract manufacturer of telecom gear had seen a "phenomenal downturn" in demand. He said revenues for the current quarter would fall sharply and that Solectron would cut 8,200 jobs, or 10% of its workforce.

It won't get better anytime soon. The closing of the capital markets has left dozens of half-built upstarts gasping for cash. They have huge debt loads, they can't get new financing, there's nobody to buy them out, and their businesses are generating less money than expected because of brutal price wars. Bear Stearns & Co. analyst James H. Henry predicts that half of the 50 publicly held upstarts will disappear through bankruptcy or merger over the next few years.

WEAKLINGS. Two dozen bankruptcies in an industry once safe enough for widows and orphans is no longer unthinkable. For example, PSINet Inc. (PSIX ), one of the leading providers of Internet backbone services, has $3.4 billion in debt, annual interest expenses of more than $300 million, and a business that doesn't generate any cash. On Apr. 3, the company conceded it will probably have to file for bankruptcy protection. And remember Alex Mandl, the onetime heir apparent at AT&T? In 1997, he left AT&T to become CEO of Teligent Inc. (TGNT ), which planned to provide local telecom services using innovative wireless technology. With revenues growing more slowly than expected and financing drying up, Teligent could end up in bankruptcy court. It has $1 billion in debt, more than $100 million in annual interest expense, and widening losses from operations. In its latest Securities & Exchange Commission filing, Teligent's auditors said the company may not be able to survive. Michael Kraft, senior vice-president at the company, says Teligent has cash to last through June and is trying to raise more.

The telecom giants aren't in such dire straits, but yesterday's powerhouses are weaklings today. Many experts think AT&T, WorldCom, or Sprint could be acquired in the next two years. "The only thing standing in the way are the regulators," says one telecom exec. That barrier may not last long: FCC Chairman Michael K. Powell has said he favors less government interference in markets.

Europe's goliaths could fall, too. Shareholders are clamoring for the resignations of the heads of the three biggest carriers--British Telecom, France Télécom, and Deutsche Telekom. BT is the most likely takeover candidate among the major players. With intense competition in its domestic market and heavy debt from wireless auctions, BT's market cap has dropped by more than 60% since the beginning of 2000, to about $50 billion. Its credit rating has been cut. And the British government is less likely to stand in the way of an acquisition by a foreign buyer than, say, the French government.

For the next year or two, bankruptcies and mergers will sweep the industry. The assets of bankrupt companies will be sold off for as little as 25 cents on the dollar to the few remaining strong players, including Verizon and SBC. Capital spending will fall, hurting the other tech companies that have grown dependent on steady increases in expenditures. The financial institutions holding telecom debt could face a crisis. And the economy could slip into its first telecom-driven recession.

Relief could come in 2002 or 2003, when the industry has a shot at becoming a profitable, growing business for the remaining players. "We're weeding out the weak," says Rick Ellenberger, chief executive of Broadwing Inc., which provides local phone service in Cincinnati and data services nationwide. "At the end of the day, this can be a good business." The end of the dark days of telecom, however, are still a long way off.

By Peter Elstrom

With Heather Timmons in New York

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