It's "Merge, Buy, or Die" in Telecom

Although even the strongest players carry enough debt to make them questionable suitors, sweeping consolidation seems inevitable

The man with the cowboy boots is gone. Throughout a 17-year ride in the phone industry, Bernard Ebbers cultivated a rebel image with his penchant for Western wear and his iconoclastic take on the phone business. His revolution ended on Apr. 30, when he resigned as CEO of No. 2 long-distance carrier WorldCom (WCOM ), a company he had built by acquisition from his original base as a rural long-distance reseller in Jackson, Miss.

Ebbers' abrupt departure -- "this was something I hadn't planned for," says CEO-designate John Sidgmore, the former head of WorldCom's Internet unit -- if nothing else is an indication of the pressure-cooker atmosphere that's reshaping an entire industry.

The WorldCom news capped a harrowing April for the telecom business. On Apr. 16, urban fiber-optic network operator Metromedia Fiber Network (MFNXE ) defaulted on $975 million in debt held by Verizon after a 30-day grace period expired. A week later, upstart long-distance voice and data wholesaler Williams Communications Group filed for Chapter 11 bankruptcy protection.


  Meanwhile, all four of the supposedly bullet-proof Baby Bells announced earnings shortfalls for the first quarter. One -- Qwest Communications (Q ) -- faces its own liquidity crisis, thanks to Wall Street doubts about the quality of its earnings and a heavy debt load. On the same day Ebbers resigned, Qwest announced a first-quarter loss of $162 million, equal to 10 cents a share, more than twice what analysts had expected and considerably worse than a year earlier, when it had profits of $218 million, or 13 cents a share.

Investors got the message: By April's end, the industry's stock indexes were down 25% vs. early March.

Ebbers' exit underscores a number of accelerating trends that will shake the foundations of the $300 billion U.S. telecom industry. Margins on voice and long-distance will continue to erode, as even the healthiest incumbents cut prices to win market share. Telecom service providers and equipment makers will also be forced to continue cutting costs, putting their already lean operations on starvation diets. Debt reduction will become a key to survival, even for the strongest companies. And increasingly, "merge, buy, or die" will be the watchwords in telecom.


  How the pieces will fit back together once the carnage ends remains unclear, since even the strongest players carry enough debt to make them questionable suitors. Yet consolidation seems inevitable. "You are going to have a smaller number -- three or maybe four -- integrated telcos, and that's it," predicts Paul Sagawa, an analyst with Bernstein Investment Research & Management.

At the top of the consolidation food chain are the Baby Bells. Despite some reversals of fortune of late, they still hold the best hand because of their solid cash flows and 45% operating margins from local service. Still, only the two strongest, SBC (SBC ) and Verizon (VZ ), look robust enough to make serious purchases. In fact, many analysts think SBC will acquire BellSouth, which had first-quarter revenues of $7.1 billion, about half that of the bigger companies. The two already have a joint venture in Cingular, the nation's second-largest cell-phone network.

The Bells are likely suitors for the flagging long-distance pure plays

The fourth Baby Bell, Qwest, could mesh well with Verizon. Qwest's long-distance network and strong relationships with business customers would be attractive to the largest Baby Bell, which is trying to branch out of residential services, though a deal would be far from a slam dunk: Qwest carries $25 billion in debt from its acquisition of U S West in June, 2000. Verizon, which is debt-laden itself, would also have to get past persistent rumors that Qwest's earnings figures have been aggressively stated. Still, those same two downsides are likely pressuring Qwest to do a deal sooner rather than later.

Aside from buying each other, the Baby Bells are also likely suitors for the flagging long-distance pure plays -- Sprint (FON ), WorldCom, and AT&T (T ). All are facing rapid erosion of customer bases and margins in their traditional businesses. That's particularly true in residential long-distance, where the Baby Bells have grabbed 20% of most markets they've entered -- though not often profitably.


  Of the three major long-distance carriers, WorldCom is under the most pressure to merge. It enacted a poison-pill provision in March to head off low-ball suitors or hostile take-overs. But that was before its stock plunged to all-time lows in the $2 range, as Ebbers departed and rumors circulated of a Chapter 11 bankruptcy filing.

The company insists that it has no plans to seek bankruptcy protection. "We don't believe that there is any way under any scenario that we are going to run out of cash in the foreseeable future," said Sidgmore in a conference call with analysts. Ebbers built the most extensive national data-transmission network in the U.S., along the way collecting a grade-A list of corporate data customers. Still, some analysts think WorldCom may need protection from creditors to pare down its obligations and make itself attractive to a potential suitor.

Of the three, AT&T might be the most attractive buy. Ma Bell's business telecom unit still dominates the corporate market -- something the Baby Bells covet as they aim for higher-margin businesses. Further, AT&T's debt load of $15 billion is a lot smaller than WorldCom's.


  Sprint appears to be a less attractive target than AT&T but more enticing than WorldCom. As the perennial third company out, Sprint doesn't have the heft of its two big rivals in either data or voice services. But its wireless business is attractive to Verizon, which uses a similar technology standard and could easily merge the two networks.

Acquisitions of either Sprint or AT&T would have the added benefit of winnowing down the existing field of six national wireless players -- and lessening the hypercompetition in pricing that's creating huge losses in that market.

The logic of these mergers may be irresistible

A significant barrier to consolidation is the debt load the Baby Bells are carrying. Verizon is $60 billion in hock, and SBC is wary of drawing down too much capital and exposing itself to Wall Street's wrath. Yet the logic of these mergers may be irresistible: The Baby Bells need national reach, every wireless carrier needs less competition, and the long-distance carriers need a way out of a disintegrating business.

Whichever company ends up owning what, the survivors will face a dramatically altered landscape -- one with fewer rivals, which nonetheless may be better-armed for cutthroat rivalry. For instance, a minority the few surviving competitive local exchange carriers (CLECs), such as XO Communications and McLeod, are struggling to avoid Chapter 11 but have had significant capital infusions and will likely continue operations. As they return from the brink, they'll mount an ongoing challenge to the Baby Bells in selling voice and data services to businesses in lucrative urban markets. The upstarts will be fewer in number but equipped with more experience and reasonably clean balance sheets that give them the leeway to execute long-term strategies for building market share.


  In fact, the Bells' local monopoly appears to be in some jeopardy. During this year's first quarter, their sales of traditional service to new customers have been "pathetic," scoffs Bernstein's Sagawa. And substituting new carriers for old, by both businesses and consumers, appears to be picking up.

Take the case of Jonathan Blitt, the president of network systems and services for ITT Industries' U.S. operations. Blitt hasn't been satisfied with his Verizon service. "Wherever there are monopoly organizations, there are customer-service issues," he says. (Verizon didn't return a BusinessWeek Online request for comment by publication time. But it has said its customer service is improving, and it will continue to make investments in that area.) So during the last week in April, he decided to check out Winstar, a subsidiary of IDT Communications.

That's right, the same Winstar that entered Chapter 11 in April, 2001. IDT Communications bought it for $42.5 million last December, a song considering that Winstar had sunk $5 billion into building its network. Now, Winstar is back and fighting for deals -- with very little debt.


  What's more, Winstar and other CLECs aren't the only competition. The Baby Bells are increasingly facing off against cable companies that provide telephone lines and broadband data services to homes and small businesses. And long-distance incumbents AT&T, WorldCom, and Sprint -- should they remain independent -- are all striving to make inroads into local-phone service. Sprint has more than 8 million local customers, AT&T more than 3 million. "We're not going to do less in the local market. We intend to do a lot more," says AT&T President David Dorman.

And on Apr. 17, WorldCom rolled out a flat-fee local-calling plan it calls Neighborhood. It's now available in 32 states, and the company promises to offer the service in the 48 contiguous states by yearend.

Another new reality will be that Baby Bells on steroids will increasingly compete against each other in a post-consolidation world. That's already starting to happen in the wireless market, where Cingular, a consortium led by SBC, goes head-to-head in some markets with Verizon Wireless in selling nationwide calling plans.

Telecom players still have room to cut costs more

The growing adoption of wireless as a substitute for traditional phone lines will introduce another potent brand of competition. "Wireless is the nearest-term competitor to the Bells," says Jerry Paul, a managing director at Denver hedge fund Quixote Capital. Paul's own office manager has ditched her wired phone because it's easier to keep a mobile phone than divvy up wired phone bills with roommates.


  The one bit of wiggle room most telecom players still have is the ability to reduce costs -- and thereby ultimately reduce debt. A good example is Verizon, which for four quarters straight has reduced expenses in its domestic telecom unit -- in this year's first quarter, by $400 million. Or look at telecom services wholesaler Level 3: In the first quarter, it reported expenses of $170 million, down 35% from the same period a year earlier.

One byproduct, according to telecom consultancy RHK Associates, is that capital spending on new telecom equipment will continue to suffer. By RHK's count, such spending peaked in 2000 at $90 billion in North America. It could bottom out at $39 billion in 2003, a 56.7% decline.

That's particularly bad news for the industry's equipment makers, which may be last to experience a recovery. Witness fiber-optic manufacturer Corning's (GLW ) recent announcement of 2,000 layoffs on top of last year's 11,000 -- dashing its earlier hopes of a rebound in 2002. "Nine out of 10 of the equipment companies are going to go out of business," predicts Ron Vidal, group vice-president for new ventures at Level 3.


  Worforce cutbacks such as Corning's are continuing, ironically, despite strong growth in demand for data services. According to telecom industry analysts TeleGeography, Internet service providers boosted their U.S. bandwidth by 150% to 190% in 2001. Data traffic is growing at 100% year-over-year, according to Roland Van Der Meer, a general partner with communications venture-capital firm ComVentures. "There are not many markets like that in the world," he says.

Which is why just about every player in telecom is now counting on data as the growth engine of the future. Level 3 is rapidly expanding its "managed modem" services that handle dial-up access to the Internet for customers of AOL and other ISPs. The Baby Bells are all counting on increased fees from high-speed DSL (digital subscriber line) customers to shore up their earnings. While the broadband adoption rate has slowed, service providers have raised fees without killing sales growth. Even slow subscriber growth yields significant revenue increases, because the carriers charge significantly more for broadband than for dial-up service.

That's one new market dynamic that will work in the industry's favor. While demand for bandwidth may not outstrip supply in the telecom backbone for years to come, it will help ISPs and telecom service providers pay off their investments in providing broadband connections to homes. More important, prices for those services appear to be stable. In fact, both DSL providers and cable modem companies have boosted prices by double-digit percentages over the past six months.


  "I think you're going to see prices for Internet service hold steady or even rise over the next five years," says Bernstein's Sagawa. "That will allow those business units to get to profitability."

In the current environment, that would be like finding the Holy Grail. But many companies won't have the chance, since not even rising Internet demand or cost-cutting can rescue every player. Indeed, with the exceptions of SBC and Verizon, just about every telecom player is on the block.

"For the service providers, the next six months will be more difficult, not less," predicts AT&T President Dorman. Telecom executives and investors alike hope that will prove the old adage -- that things are always darkest before the dawn.

By Alex Salkever

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