February 21, 2002

Worse yet to come for telecom industry

Despite cheery forecasts, telecommunication bankruptcies will continue, possibly wiping out as much as US$100-billion in shareholder wealth

Wynn Quon

Despite Nortel's recent bad news -- that it would have trouble meeting its first quarter revenue targets -- the company believes it will be profitable by the fourth quarter of this year. You can't blame Nortel for the rosy spin, but fourth quarter profitability is unlikely to happen. The truth of the matter is that the telecom flame-out that began last year is still raging and things are likely to get worse. Here's why:

1. Disappearance of the New Economy carriers. They were supposed to herald the age of unlimited bandwidth. Instead they gave us one of the biggest industrial meltdowns ever. Winstar Communications was one of the first to burn out in April last year, then there was Teligent, XO Communications followed quickly by 360 Networks, and now Global Crossing and McLeod USA. All eyes are on who's next. Williams Communications is already billowing smoke. It suffered US$300-million in negative cash flow in the past 9 months and holds US$5-billion in debt. Level 3 Communications is barely cash flow-positive and may soon be in violation of some of its credit agreements. As a group, these companies have destroyed more than US$180-billion of shareholder wealth. But even if these companies never had sustainable business plans, they had one redeeming feature for companies like Nortel and Lucent. They spent a lot of money on telecom gear. The disappearance of the New Economy carriers means no chance of a rerun of the 1999-2000 spending boom. It's also an effective death sentence for dozens of small telecom equipment startups because the New Economy carriers were supposed to be their biggest customers.

2. Tainted telecom. The big bankruptcies have cast a pall over the entire industry. Global Crossing is a case in point. This company stands out as a poster child of all that was wrong with the New Economy. It spent US$15-billion on an 85,000-mile fibre network that no one wanted. Its revenue accounting was suspicious and may have involved phantom transactions with other cash-strapped telecom firms. It spent more money on political handouts than Enron did. And of course it gave investors the de rigueur twist of the knife -- founder Gary Winnick walked away from the fourth largest bankruptcy in U.S. history with US$633-million from stock sales. The fallout is that banks and bondholders are now thinking the telecom sector is too hot to handle. Global Crossing defaulted on US$12-billion of debt, McLeod USA on US$6.2-billion of debt. By the time this downturn is over, the final toll on the financial community may likely hit US$100-billion. The problem is that good telecom companies will get hurt in the credit squeeze. Nortel Networks issued US$3.3-billion of new debt in 2001 to bolster its balance sheet. If it were to try to do that today, it would find the credit terms much more onerous. Smaller telecom companies will find themselves locked out entirely from the debt markets. This will only add to the casualty list.

3. Capital spending drought. A lot of the talk about forthcoming increases in capital spending by the mainstream carriers is just wishful thinking. Here's a sobering fact: Even after its recent plunge, the estimated capital expenditure of US$50-billion in 2002 by the top 12 carriers in the United States is still high, matching the amount spent in 1998. Analysts who expect a quick bounce-back are ignoring the fact that the competitive environment has changed. First, why build more infrastructure when your competitors are dying off? Smart carriers can now buy the bandwidth capacity for the next decade from their bankrupted comrades. And for pennies on the dollar. (Singapore Telecom in partnership with Hutchison Whampoa is offering a measly US$750-million for Global Crossing). Second, the telecom carriers themselves have consolidated. At the start of the 1990s, the local telephone market in the United States was split between the seven so-called Baby Bells and GTE. Now, after a decade of mergers and acquisitions, it's down to four supercarriers. The dwindling of competition makes for a less dynamic, more conservative industry with greater power over equipment suppliers.

4. Carriers' sluggish performance. Adding to the pressure on carrier spending levels are their lacklustre financial results. Verizon (the gargantuan offspring of a merger between Bell Atlantic, NYNEX and GTE) reported a paltry 0.8% year-over-year increase in revenues in the fourth quarter. SBC did better with an anemic 1.2% growth. Qwest did much worse, reporting a 6% drop in 4th quarter revenues. In response, capital spending plans have once again been cut for this year. The problem is that these cuts haven't yet shown up "downstream" yet in the financials of the equipment vendors, but they will.

5. International telecom slowdown. While we've focused on the North American market simply because it is the largest, the international telecom market has little good news to offer. In fact, it may prove to be another bad news surprise. On a global basis, telecom spending actually declined only 1% to US$274-billion in 2001, thanks to large expenditures in China and Latin America. That's unlikely to bail us out again this year. Instead a survey of hundreds of carriers worldwide by ABN Amro suggests that spending will drop by 17%.

Is there any good news? Yes, the market for high-speed residential Internet access is still robust. Despite the gloom, the wired world isn't going away. The wrenching adjustment feels rough only because we're downshifting from what was a euphoric unsustainable growth rate. In the long run, telecom equipment spending growth should revert to a figure that's a few percentage points above GNP growth, i.e., low single digits.

What's the outlook for the stocks of telecom equipment companies? Many of these stocks have been chainsawed over the past 12 months. Nortel, Alcatel, Lucent and Ericsson, for example, are now selling for around one times sales, where before they were selling for up to 10 times sales. One times sales is not expensive but there are still two downsides facing these stocks. One is a psychological one. At some point, investors will simply run out of patience at the repeated predictions of a spectacular recovery that doesn't come. That point may unfortunately take telecom equipment stocks down another 50% from where they are now. The second is a more substantial danger: in a tightened credit environment, cash flow management will be critical to long-term survival. Companies with too much debt and not enough cash flow may find this downturn to be their last.

Wynn Quon is chief technology analyst at Legado Associates. E-mail: wynn_quon@hotmail.com