When Will the Telecom Depression End?

The ongoing disaster in telecommunications girds the globe, growing in one place just when it shows signs of abating elsewhere

The telecom crisis is reminiscent of a classic scene in The African Queen. Humphrey Bogart and Katharine Hepburn, desperate and lost on the Ulonga-Bora River, rip pieces of wood off the little steamer and use them to fuel the vessel's engine. Today's telecom companies, struggling to survive one of the greatest busts in business history, are slashing prices below cost and selling precious assets. "Neither one is a long-term survival strategy," says Stephan Beckert, research director at TeleGeography Inc., a Washington consultant. Hepburn and Bogart were rescued by a last-moment stroke of good fortune, but today's telecom titans won't escape catastrophe so easily. More than a cyclical downturn, what they're experiencing is a full-blown industrial depression, one that has wiped out half a million jobs and $2 trillion in U.S. market value. That's about as much as the savings and loan crisis of the early '90s. And turmoil in the $2.3 trillion global industry shows few signs of abating. In September, Lucent Technologies Inc. (LU ) and French equipment maker Alcatel (ALA ) issued dire revenue warnings and new layoffs. Throughout telecom, frenzied cost-cutters come up short again and again. They can't catch up to collapsing revenue or predict the timing of a recovery. "This is an unprecedented period," says Lucent Chief Executive Pat Russo.

How long will the bloodletting go on? BusinessWeek spent a month examining the capacity for each type of telecom service, from long-distance to wireless, and comparing it to worldwide demand. The results show that capacity continues to dwarf demand. Prices in America and Europe remain under pressure. Meanwhile, rollouts of new cables promise to extend excess capacity to regions such as Asia that have been spared much of the pain to date. "We're not seeing any turnaround," says BellSouth Corp. CEO Duane Ackerman.

The upshot is that the crisis could last until at least 2004. In the U.S., traffic at the core of the networks is leaping ahead at 85% a year, with Europe and Asia at similar paces. Within two years, that should soak up excess capacity of networks in operation, which are running at 35% of capacity in the U.S. and Europe and at higher rates in Asia. An economic upturn, expected by the end of 2003, could spell recovery for U.S. telecom carriers six months later. Europe is expected to follow suit in late 2004.

But things could get worse. If the world economy continues to struggle or if telecom companies fail to lop off capacity and come up with lucrative new data services, this depression could continue through 2006. Even when recovery arrives, most of the once-robust telecom players are likely to perform, at best, like stolid, slow-growing utilities through the end of this decade. Growth is likely to be 2% or 3% a year, predicts Lawrence Kenny, head of the telecom practice at PricewaterhouseCoopers.

The road to recovery for the beleaguered industry involves a three-stage process. The first stage, happening now, is managing the glut. This involves slashing costs and struggling to come to terms with massive debt. This period, which should last another two years, will continue to drive many companies to the brink of insolvency or beyond. But relief won't arrive until stage two, consolidation. That's not likely to come until mid-decade, when the surviving companies have cleaned up their balance sheets and can afford to snap up rivals who have been driven to rock-bottom prices--pennies on the dollar.

Far-sighted companies are already at work on the third stage, transformation. The idea: Players that survive this turmoil will emerge with new business models. Instead of selling old-fashioned access to a network, they'll offer a host of value-added services, from encryption and wireless teleconferencing to management of huge video, music, and game programs.

They'll need loads of these products to fill up today's empty pipelines. Much of the build-out was based on dreams for revenue and traffic growth that fell far short. Internet traffic was supposed to double every three months, but it's growing at just a quarter of that pace. Today, only 1% to 2% of potential long-distance capacity in North America and Europe is in use. The vast majority is dormant cable in the ground. No wonder the price of a speedy business connection between New York and London has fallen 95% during the past three years, to $6,000 a month.

Much of the problem comes from technology itself. Dazzled by the engineering prowess of optical systems that can download the entire Library of Congress in a flash, few gave any serious thought to the economic consequences of wiring the world with these marvels. Now, super-high-speed technology is out of the lab, and capacity growth is out of control. This winter, British carrier Cable & Wireless (CWP ) and Alcatel will begin operating a $443 million transatlantic cable called Apollo. Loaded with the latest in optical and Internet Protocol communications equipment, the cable's four pairs of hair-thin fibers will be able to carry 3.2 terabits of data--30% more than all current transatlantic capacity combined.

And just try trimming back that capacity. Gap Inc. can pull last season's unsold sweaters off the shelves and sell them at discount prices, and then stock the shelves with a new lineup of higher-priced goods. But telecom companies can't pull fiber out of the ground. The result: Capacity, the root of the telecom depression, doesn't go away.

In the midst of this depression, certain sectors, however, remain healthy. Data from Internet services and network management are growing 10% to 20% a year for many companies. Trouble is, those sectors represent only a fraction of telecom revenue. The biggest sectors, local and long-distance voice, are in decline and are unlikely ever to grow again. In fact, many companies can see the day when voice calls will be offered as a complimentary service to accompany lucrative data subscriptions. "In our projections, voice will be free," says Ilkka Raiskinen, Nokia Corp.'s vice-president of mobile applications & services.

Even in wireless, the booming growth business of the past decade, revenues are flattening out as the wave of new subscribers subsides. The wireless Internet, the great hope from the bubble years, is trudging along behind expectations. Says Lawrence T. Babbio Jr., vice-chairman of Verizon Communications: "We don't see any growth trends."

And they don't need much convincing these days to slash capital spending. SBC Communications Inc. (SBC ) Chief Technology Officer Ross Ireland says he used to buy gear to meet multiyear forecasts. Now SBC saves money with a just-in-time approach. "Before the downturn, it didn't matter if you guessed wrong because you'd just grow into it," he says. But current penny-pinching is leaving equipment makers such as Nortel Networks (NT ) and Lucent Technologies struggling to survive. To make it, they and the rest of the telecom industry face a three-step recovery program:

WORK OUT THE GLUT. The first period of the recovery, the glut, entails unremitting pain and apparent paralysis. Even bankrupt carriers struggle to eke out sales, which means that capacity does not disappear. Consolidation promises relief. But that's still a ways off. Carriers are shouldering far too much debt for acquisitions. For this nasty stage to end, the markets have to work their malicious miracles: Survivors must clean up their balance sheets, usually at the expense of investors and creditors. Meanwhile, losers must be ground down mercilessly, until they are cheap enough to buy.

North America has been wrestling with overcapacity for two years and is about halfway through the process. A survey of 20 major long-distance and local trunks shows that networks are running at about half of ideal capacity, according to telecom researchers RHK Inc. Local and long-distance carriers generally expand capacity on a route when capacity utilization reaches 70% to 75%. The telcos are slashing their capital spending by up to two-thirds--which puts recovery at two years away.

A few signs of stabilization are finally emerging in the depressed market. The price of a high-speed circuit between Los Angeles and New York, which fell 50%, to $13,000, between the summers of 2001 and 2002, has inched up in recent weeks. Sprint (FON ) cancelled a high-speed Internet service called ION, which would have added more capacity. "I won't predict when growth will resume, but the market is cleaning itself up right now," says David Dorman, president of AT&T.

One wild card: Some creditors of bankrupt WorldCom Inc. tell BusinessWeek they want to swap debt for equity in a new company. They are pushing other creditors to allow WorldCom to emerge from bankruptcy debt-free, which could spark a price war a year or two from now. Other carriers might start sooner. "I'm a low-cost share taker," says John J. Legere, CEO of Global Crossing Ltd., which is expected to emerge from bankruptcy this year with just $200 million in debt, down from original liabilities of $12 billion.

In some markets, conditions may get worse before they get better. Catapulting demand in Asia, for example, has buffered the region from much of the nastiness to date. Wireline phone revenues in Asia have fallen 10% over the past two years, vs. a 50% decline in North America and a 33% fall in Europe. Yet despite a strong economy, a rising population, and soaring demand for telecom, worrisome signs are emerging. Later this year, Tyco's telecommunications unit will begin operating a new undersea cable that will double transpacific capacity.

The glut grows relentlessly in other markets as well. Last year, the price of a high-speed circuit between Tokyo and Hong Kong fell 27%, to $62,000 a month. But four new cables have begun service in the region during the past eight months, raising the risk of a price war.

One big variable is the economy. In the U.S., consumers are both yakking on the phone and surfing the Net more than ever. This makes up for falling prices and keeps spending flat. But with corporations slashing costs and laying off workers, businesses have cut phone bills by about 6%, paring $9 billion from a $141 billion market.

And telecom isn't likely to see a surge in business demand soon. An uptick in usage should lag economic recovery by six months. That means relief could arrive in 2004. This could trickle down to the equipment makers some six months later, producing modest growth in the second half of 2004.

CONSOLIDATION. It's waiting to happen in Europe as well as North America--but it will keep waiting for at least another year. If markets permitted, wireless giants Verizon (VZ ), Deutsche Telekom (DT ), Vodafone (VOD ), and perhaps Japan's NTT DoCoMo (DCM ), would be gobbling up smaller competitors, driving down costs, and jacking up prices. Local and long-distance carriers like AT&T (T ) and BellSouth (BLS ) might have signed long ago. But debt-wary markets will not tolerate such maneuvering today. Even the whisper of new equity or debt offerings provokes warnings of downgrades from rating agencies and investor stampedes.

For a consolidator on a holding pattern, look no further than Verizon. The largest of the Bells, Verizon could take a large step toward dominance by buying a national long-distance carrier, either WorldCom or AT&T. And it could tighten its grip on the U.S. wireless market by gobbling up Sprint PCS (PCS ). The total outlay for AT&T and Sprint PCS: perhaps $25 billion--peanuts back in the bubble.

But that bubble has popped, and Verizon, with $45 billion in long-term debt, is busy cleaning its balance sheet. The company is slashing investments and paying down debt with its $2.7 billion in net income. Analysts say that Verizon won't be out shopping for more than a year.

This is where the passage between phases one and two--glut and consolidation--gets tricky. When one carrier lines up the first big acquisition, competitive pressure could push others into the hunt. That would punish balance sheets while hastening a necessary consolidation.

In the next year, though, look for a slew of buyouts on the cheap. Consolidators like Integrated Device Technology Inc., a Net voice company, are prowling the littered landscape for bargains. Last year, it acquired bankrupt carrier WinStar, for $42 million, a small fraction of its book value. And if WorldCom fails to emerge from bankruptcy as an independent company, look for IDT and the Bells to buy it in pieces.

Deutsche Telekom, which paid $26 billion to buy upstart wireless carrier VoiceStream at the height of the market, is now ready to sell the U.S. carrier for much less so it can pay down its massive debt. So far, no buyers. When the German company finds one, perhaps within the next year, the consolidation period will be under way.

TRANSFORMATION. Even while wrestling with capacity and cost issues, phone companies must focus on the longer term. To survive, many must undergo a fundamental transformation. In a competitive environment, the century-old practice of charging customers for access to a network has produced a punishing, low-margin business.

To make money in an age of plentiful networks, carriers must market new content and value-added services that flow through their pipes. The companies already have billing relationships with customers--a huge advantage--but have to come up with services to sell. "It's really about transforming telecom from a transport industry into a services industry," says Microsoft Corp.'s Pieter Knook, corporate vice-president for network services providers and mobile devices.

This is already happening. Over the past decade, AT&T has grown its service arm into a $4 billion enterprise that competes with consulting and service companies. In time, services may become the heart of AT&T and the carrier division may be spun off.

The signs of change are clearest in wireless. In Japan, wireless data pioneer NTT DoCoMo has let thousands of other companies offer an endless array of services, from games to music, on its network. DoCoMo gets a small fee for every transaction. "DoCoMo has created a new model of the telecom as marketplace," says consultant Andrei Jezierski of telecom researcher i2 Partners. AT&T Wireless, a DoCoMo partner, plans to import the model to the U.S.

In the end, telecom companies may eventually even spin off their networks and concentrate on services. The first signs of this fragmentation are evident. Across Europe, so-called virtual phone companies such as Virgin Mobile are selling wireless subscriptions and simply renting network capacity from incumbents.

Even in the midst of this industrial depression, the elements of telecom's recovery, from consolidation to new business models, are coming into focus. The industry that emerges from this will be humbler and, yes, poorer, than it was in the bubble. But even in these dark days, which are every bit as treacherous as the Ulonga-Bora River, the shape of a new industry is in sight.

Corrections and Clarifications ``The telecom depression'' (Special Report, Oct. 7) should have referred to consolidator IDT Corp., not Integrated Device Technology Inc., which is a different company.

By Steve Rosenbush in New York, with Roger O. Crockett in Chicago, Charles Haddad in Atlanta, Jack Ewing in Frankfurt, and bureau reports

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