Sargasso Sea

Red Herring :: August 2002 ::If you’re a company executive looking forward to innovative, next-generation broadband services, you might want to pull up a chair. You’re in for a long wait. Why? Because cash-strapped Baby Bell phone companies, like SBC Communications, Verizon, and BellSouth, are too stingy to invest in new network technologies to deliver those services.

In an industry that’s had an insatiable appetite for new technologies over the past few years, this may sound like telecom heresy. But the grim reality has sunk in, and the options are to buckle down and keep costs low, to reduce debt, or to face extinction. “The situation today is similar to the Sargasso Sea: there is no current, no wind, and no waves,” says Allan Tumolillo, chief operating officer of the market research consultancy Probe Research, referring to an area in the Atlantic Ocean where current and atmospheric conditions cause stagnation. “Nothing is going to change for some time,” he adds. “We will drift until 2004.”

Baby Bells and other large players, like Sprint and AT&T, are looking to keep cash-flow positive and thus protect their credit ratings. Many carriers were scared by the pending collapse of WorldCom. Within a week of the company’s debt being downgraded to junk status late this spring, its stock sank below $2 a share (Nasdaq: WCOM). At press time, it was trading for considerably less than $1. Any downward revision on their credit ratings means companies will have to pay more in interest costs, which in turn has an adverse impact on their earnings. “There is a complete lack of faith in the telecom sector, and EBITDA [earnings before interest, taxes, depreciation, and amortization] has become meaningless; everyone is looking for cash flow-positive companies,” says Mr. Tumolillo.

PROCEED WITH CAUTIONLarge telecom carriers are very cautious about investing in new technologies to deliver broadband services. Among the offerings that most observers say will shape the marketplace in the long term are wavelength service, bandwidth on demand, and video on demand.

Wavelength service enables business customers to set aside dedicated bandwidth, assigned to them by their service provider, for specific business purposes, like teleconferencing or large marketing efforts.

Bandwidth on demand is a more dynamic service in which a telecom carrier sells a business customer the right to order large network circuits between two or more points whenever they’re needed. With bandwidth on demand, the customer is assigned a specific color band, or wavelength of light, on an optical network. The ability to order bandwidth only when it’s necessary helps companies avoid costly, long-term fixed contracts for bandwidth.

The much-ballyhooed video on demand, or the delivery of streaming video to an individual Web browser, has faced several technological problems, including clumsy archival features and a lack of adequate bandwidth. The carrier Qwest Communications shut down its Qwest Digital Media operations because of lackluster customer demand and huge debt problems. Earlier this year, Enron Broadband Services bailed out of the business altogether (and a lot of other businesses, as well).

That’s why carriers are sticking with proven, cost-effective moneymakers like T1-circuit (a dedicated connection over which data can be transmitted at 1.5 Mbps, or 30 times faster than a dial-up connection), frame relay (a high-speed packet-switching protocol used in wide area networks, or WANs), and DSL technologies, as well as plain old voice services. Mr. Tumolillo says the Baby Bells, which are eager to cut costs, will continue to sell traditional services like T1 and to make as much profit as possible, since most of their equipment has already been depreciated on their balance sheets. In the coming months, spending on fancy new technologies will continue to drop sharply, as carriers looking for a clear path to profits turn to existing technologies like voice over IP (VOIP), virtual private networks (VPNs), and ethernet over copper.

From Genuity to AT&T, almost all carriers have some sort of VOIP initiative in the works. But it will be a while before this technology has a meaningful impact on their revenue. And VOIP isn’t without its shortcomings. Poor quality of service and problems with packet loss and delays are issues that worry large companies–no one wants choppy or dropped calls, so corporations have been sticking to traditional voice services.

Optimists like Steven Blumenthal, chief technology officer with Genuity, a telecom service provider in Woburn, Massachusetts, are betting that VOIP will be especially attractive to large corporations that need to communicate with multiple international locations within WANs, in which VOIP has proven to be quite effective. VOIP allows large multinationals to circumvent the local switched networks and can save about 17 percent in communications costs within the first 12 months alone, according to the research firm Current Analysis.

Similar economic arguments are being made for VPNs. According to a recent study by the research firm IDC, the total market for IP-based VPN services in the United States will grow from just more than $5.4 billion in 2001 to nearly $14.7 billion in 2006, an annual growth rate of 22 percent. As an increasing percentage of the workforce becomes mobile, most companies are looking for ways to cut costs and still provide their employees with secure access to the corporate networks. While frame relay has been a traditional option, many say that VPNs are cheaper and easier to deploy and manage.

Since carriers are looking to make deep cuts in their operational expenses, which sometimes account for nearly 50 percent of total costs, ethernet over copper is an easier-to-run option, compared to, say, optical networks, DSL, or even T1 technologies. As a primary carrier of data, ethernet over copper could replace DSL in the small and medium-size business markets, which are looking for more bandwidth but refuse to spend $600 a month for a T1 connection.

TELECOM HANGOVERThe telecom industry is paying for its excesses. From 1996 to 2000, telecom carriers of all shapes and sizes spent billions of dollars on new equipment and networks that crisscrossed the globe. The perceived demand for bandwidth, which according to some estimates was doubling every three months, prompted an enormous investment frenzy in infrastructure, the likes of which hadn’t been seen since the railroad boom at the turn of the 20th century.

So what do these dire market conditions mean for startups, and even established players, that were expecting to get new orders for state-of-the-art technology? They aren’t likely to win big orders for their products anytime soon–that is, unless the technology permits the carrier to get a quick return on investment. “It will be two years before the startups get any real orders,” says Greg Blonder, general partner with Morgenthaler Ventures, a venture capital firm based in Menlo Park, California.

The only new technology that might prove successful is ethernet over copper, since it helps Baby Bells compete more aggressively with the cable companies that have started eating into their T1-related revenue.

The indifference toward new technology in the telecom market is a huge concern for large service providers like Genuity, which looks to carriers to provide services that it can then package for sale to its base of 5,000 corporate customers. “There is a fair amount of capacity at both the optical and IP layers, and our focus is on consuming that capacity,” says Mr. Blumenthal. Genuity is also keeping its expenses low, and is interested in service offerings that provide a quick return on investment.

Mr. Blumenthal’s cautious approach is supported by data from RHK, a market research firm in South San Francisco, California, which expects North American telecom capital expenditure in 2002 to fall to between $46 billion and $51 billion, from $77 billion in 2001. And the expenditure level is expected to remain flat throughout 2003. To put things in perspective, two years ago carriers spent more than double their current capital expenditure budgets–a whopping $108 billion–on equipment purchases.

The consensus among research groups is that the first signs of recovery for the telecom industry should begin sometime in 2004. Some observers even say that time frame might be too optimistic. That’s a long time on hold.