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June - 2001 - issue > Wall Street View
And God Said,
Friday, June 1, 2001

Just a few years ago, people considered utilities and telecommunications, especially telephone company, stocks to be safe, solid investments. They were the so-called “defensive stocks” that could weather a stock market storm. Ma Bell (AT&T), in fact, was known as the “widows and orphans” stock. But AT&T has gone from a high of 61 to a low of 16 in just nine months. Lucent, spun out of the old AT&T with Bell Laboratories and other networking assets, is rumored to have filed for bankruptcy last month and is in the midst of financial restructuring discussions with its bankers. What’s happening here?
The race to build new networks to compete with the old networks of the entrenched players (AT&T, MCI, Sprint) and the rise of IP-based packet-switching versus the old circuit-switching networks spawned many new companies in this broad space. The regional Bell operating companies (RBOCs, or “Baby Bells”) still have a stranglehold on the “last mile,” that last strand of fiber or copper wire of the network that goes to the house or business. Consumers know how slow and bureaucratic the Bell companies are. They do have monopoly on local networks — although competitive local-exchange carriers (CLECs) have taken about 8 percent of their business in the last few years. On the long distance side, 1980s upstart MCI (now Worldcom) and Sprint have laid fiber network to compete with the Bells and Ma Bell. But even that is almost outdated.

The Telecommunications Act of 1996 opened up the field — from carriers, to networks, to equipment makers and services providers. The law opened the floodgates of new investment in fiber networks, new CLECs, etc.; the arrival of Internet and new technologies led to faster access services such as the cable modem, DSL and now wireless services. Qwest was one of the fastest companies to take its market capitalization into billions before the “Internet Bubble.” The success of Qwest, Frontier, etc., and the demands of new markets and technology led to new investments. Money was poured into laying fiber; launching fast access service companies (like COVAD and Northpoint, both of which are in deep financial crisis on the brink of bankruptcy); starting new optical switching, networking and gear companies like Ciena, Sycamore, Monterrey, Cerent, and others; and creating companies such as XO Communications, Level 3 Communications, Williams. and more.

The Right-of-Way Advantage
Some of these were not in the telecommunications industry until five years ago. Either they did not exist at all, or they were in other industries, i.e., railroad (Qwest and EPIK), construction (Level 3), gas pipeline (Enron), etc. They had the right-of-way and the real estate where they could install fiber networks. Qwest proved that with a simple right-of-way it could lay fiber along its railroad tracks and then fill up the capacity later. And the stock market richly rewarded such large capital investments by giving huge PE multiples and market capitalizations. On the other hand, the old Bells were trapped with low PE multiples and dividend payouts and healthier (A and AA rated) balance sheets. It was impossible for the Bells and other entrenched players to make such huge investments without hurting earnings in the short run, dividend payouts and credit ratings. Eventually, AT&T lowered its dividend and has seen its stock dwindle for the past 12+ months.

There was once a belief that the world needed ever-increasing network capacity to carry voice, data, e-mail, audio and video traffic. But the capacity build out has been ahead of the demand curve. Moore’s famous law was applied to demand for such capacity, i.e., network traffic — that it would double every 18 months. As a result, in few short years, a dozen or so carriers have built 41 cross-country fiber networks. And there are plans for 570 more strands of fiber by 2003, boosting bandwidth capacity 70-fold.

Most of this capital investment was raised through the soaring capital markets, particularly the high yield (junk) bond market. Now, with the glut of capacity and slower demand, carrier stock and bond prices have been hit. As on the way up, so on the way down prices are driven by fundamentals but overshot by human emotions.

But if God were to say, “let there be light” to illuminate the millions of miles of dark fiber — the Gilder Report estimates that globally about 150 million kilometers of optical fiber were laid in the last two years — you need expensive gear, including routers, switches, wavelength separators, channel processors, optical amplifiers, and the like. Anticipating this demand and the explosion in data traffic VCs began pouring money into the backbone of the future networks. New companies like Avanex, Sycamore, Ciena, Monterey, ONI, to name just a few, sprang up. Recently, more players — Soma, ipVerse, CoWave, etc. — have begun to challenge Nortel, Cisco and Lucent.

Lucent has been selling telephone switches based on circuit switch technology at high-end prices. Packet-based IP telephony from companies like Sonus brought competition to the almost monopoly-like pricing of the big players. Lucent was also selling SONET (synchronous optical network) cards at very high prices and huge margins. And for capitalism, high prices and huge margins are like a vacuum in the real world where air rushes in quickly and fills it up. The price “vacuum” was quickly contested and filled by VC-backed startups like Ciena, Corvis and even established players like Cisco.

The Data Explosion
In the early 1990s, Cisco foresaw the data traffic explosion and built what the Internet needed. Cisco’s equipment and software were ingeniously designed and ruthlessly efficient at handling packet-based traffic. They were designed to address bandwidth scarcity and solved it very well. But now with all the optical fiber going into the ground, bandwidth scarcity is no longer an issue. And chipmakers like Applied Micro Circuits, Broadcom, and Ezchip are integrating more and more of Cisco’s boxes (software, wires and processors) onto single microchips. Cisco once could afford to buy R&D with a very high PE multiple stock and stay competitive with the upstarts like Juniper, ONI, Avanex and others. But it can no longer use a currency it can print — its own stock.

Stocks of many of these upstarts that went public — Avanex, ONI, Juniper, Sycamore, etc. — were bid up in the frenzy of 1999/2000. Yes, there were fundamentals behind the meteoric stock price — the promise of new technology, a huge market and an explosion of data traffic, etc. — but was the parabolic trajectory justifiable? Many of these startups had the same customers in the carrier area, from Williams Communications to Level 3, and others. It was just a bubble feeding on another bubble.

Internationally, 3G wireless applications) licenses were bid up by European companies like BT and Deutsche Telekom into tens of billions of dollars. Yes, 3G has significant advantages. For example, a cell phone browser connection will go from 19 kbps to 2 mbps and will be at DSL type speeds even when a user is traveling by train from London to Paris. But is there any money left to build out the 3G network? Or, were the billions spent by the big telecom companies used mainly to keep startup competitors from entering the market?

A neater and cheaper solution to the fiber glut and 3G overspending might be fixed wireless. It would also solve the “last mile” problem that is giving the Bell companies an entrenched monopoly in local markets.

The Bell companies will fight and their stocks will carry a sub-market multiple. The fiber glut will force prices down for voice and data communication. But just as the lower prices of Intel PC chips drove the demand for PCs and applications higher, lower prices for fiber and switches will create a demand for better telecommunications services from handhelds to wireless gadgets to broadband networks, switches, and more. The Internet Bubble and hype will have to stay subdued and the quiet revolution will march on. The upstarts have a great opportunity to answer God’s call and light up the miles of dark fiber.

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