| +=+=+The TeleChoice Take+=+=+
No part of the telecom industry will recover until the carrier
segment recovers. There’s a painful three-step treatment
process required for the carrier industry to recover:
1. Carriers must restructure their balance sheets.
2. Carriers must consolidate down to reasonably
few players.
3. Carriers must learn to offer profitable data services.
Until this process is complete, the entire industry
will continue to suffer almost unbearable pain.
The Diagnosis
Regular readers of this newsletter know that we believe the
industry’s ills have been misdiagnosed as a fiber glut. The
real problem is a company glut - too many carriers
competing for the business of too few customers, and the
related overspending required to establish these
companies and their networks. There’s a second disease
which can’t successfully be treated until the first is
eradicated, which is carriers’ continued failure to structure
data services to be profitable.
Free Market Optimism - an Unhealthy Lifestyle
We can easily trace the onset of problems back to
1995. In that year, two major forces converged to create
unbridled optimism and the launching (and funding) of
hundreds of new telecom companies.
The first force was the Internet. In 1995, the Internet as a mass
market medium was validated by the entry of Microsoft with
the free Internet Explorer browser, and AT&T with the first
consumer-oriented flat-rate dialup Internet offer. This of course
led to the Internet boom, the training of the American populace
to use networks for everything from academic research to
buying bobble-heads to habitually stealing licensed
commercial music. It, of course, led to "insatiable" demand for
network capacity.
The second force was competition. In 1995, it became clear
that Congress would pass legislation to open monopoly local
telecom markets to competition in exchange for freeing the
Bells to compete in long distance. Although that Telecom Act
didn’t become law until 1996, the funding of new competitors to
the Bells began in earnest in 1995.
Americans’ love for our free market economy is a beautiful thing.
Our embracing of competition, our belief in the ability of the
"little guy" to overcome seemingly insurmountable odds is noble.
Our desire to join in the hunt, to put our own savings at risk to help
fund innovation and competitive solutions has helped drive this
country to its technological and economic leadership position.
However, in this case, our optimism, our love and our cash
funded irrational behaviors that will continue to cause pain and
decay for at least a few years yet to come.
What did we do wrong?
In overly simplistic terms, we can think of the carrier/service
provider industry in two parts. The carrier part is all about
operating networks. The service provider part is all about
offering services to end customers. There are fundamental
economic laws that come to bear in each of these segments
that we all completely ignored.
The carrier business, as with most asset-intensive
businesses, is an economies-of-scale business. The cost of
building out a network is relatively high. The baseline costs of
operating a network (24x7 network operations center,
interconnect agreements with other carriers, etc.) are also
relatively high. To operate profitably, carriers must have
enough traffic on their network to amortize those costs across
enough units of capacity that the cost per unit is low enough to
be competitively sold at a profitable price. In simple terms,
this means that a carrier must have some minimum threshold
of revenue (which can also be measured in market share) to
cover all of its fixed costs plus all of its incremental (tied to
number of customers, number of units sold) costs. Historically,
this minimum market share threshold has been in the 10-20%
range. With the price declines of the past couple of years, this
threshold actually rises and is likely at or above 20% today.
Conversely, the service provider business, as with most
customer-centric businesses, is an economies-of-scope
business. The cost of acquiring a customer is relatively high.
And the cost of supporting that customer (customer service,
billing, collections, etc.) is relatively high. In overly simplistic
terms, to be profitable, you need to collect more money from
customers than you spend to provide service to those
customers. At the low end of the market, consumers have
well-defined finite telecom budgets, so your costs per
customer must be similarly limited. In practice, this really
can only be achieved when basic costs (brand-building,
billing system operations, customer service operations, etc.)
can be spread across millions of customers. Mathematically,
there’s only room for a small number of such competitors. At
the high end of the market, enterprise telecom/datacom
budgets are high, but so is the cost of winning and supporting
these highly sought customers. In practice, this means that to
profitably serve these customers you need to capture a very large
share of their telecom spending - which practically means that you
have to have a very broad portfolio of services and solutions that
meet these customers’ needs.
Unfortunately, we lost sight of these realities in the booming
late-1990’s. We funded too many carriers and we funded too
many service providers. Specifically, although TeleChoice
believes that the right amount of fiber was constructed, it was
built by too many companies.
Our initial mistake fueled further damages. These new entrant
players weren’t naive or stupid. They realized that their
survival depended on their ability to win customers and
revenue. With the glut of competitors, none of whom had
time to establish true differentiating capabilities, the only
way to compete was on price. In short, the irrational pricing
declines we’ve seen in the telecom industry haven’t been
caused by a glut of capacity, but rather by a glut of
competitors.
What’s the Cure?
In very simple terms, to fix the industry, we first need to
eradicate two fundamental problems:
- We need to wipe out the overspending from our system.
More clearly, we need to eliminate from the industry cost
model the money that was wasted in establishing too many
competitors and building too many separate networks.
Unfortunately, for those of us who participated in funding
these companies, that means writing off our mistakes.
These companies were funded through a combination
of debt and equity. By its nature, equity is a higher risk
form of funding (for which we, as investors, expected a
higher return) than debt financing, so as this "wiping out"
(euphemistically called balance sheet restructuring - but
most often accomplished through Chapter 11 bankruptcy)
happens, shareholders will often be left with nothing while
creditors are left with pennies on the dollar. Until this excess
cost is wiped from the system, consolidation likely cannot occur.
- With balance sheet restructuring, some companies may be
able to redefine themselves as niche players with modest
revenue and market objectives, but this will require behavior
changes which will be difficult for many to swallow.
- We need to reduce the number of broad market
competitors to a number that can sustain profitable levels of
market share and revenue. This could potentially happen
through company failures and liquidations (as happened in
the DSL space), however current trends indicate that
companies are successfully raising enough capital to fund
their way through Chapter 11 bankruptcy. Therefore the
reduction must occur through mergers and acquisitions.
- Since no one will make the mistake of acquiring a carrier
with an unhealthy balance sheet, and no creditor/shareholder
will exchange their ownership in a restructured company for
equity in a company with an unsustainable balance sheet,
this will need to wait until balance sheet restructuring occurs.
- With these two fundamental problems resolved (overfunding
and too many competitors), the industry will be able to
rationally act to resolve other critical problems, including
injecting rational concepts (like usage-based pricing and
customer incentives to shift traffic off of the peak) into their
data service offerings to transform them into profit contributors.
(See the May 2002 TeleSparks for a discussion of many of
the key issues.)
+=+=+What's Next? +=+=+
What Can You Do?
Balance sheet restructuring is a painful reality that all carriers
and service providers will need to face in one form or another.
The more interesting strategic questions surround the issue
of industry consolidation. If you are a carrier, service provider,
or a creditor to one or more of these players, please carefully
consider your role in the industry consolidation.
Specifically, consider this:
- If you are a creditor, please recognize that it is highly unlikely
that the companies you’ve funded will be sustainable beyond
restructuring. There are some exceptions (AT&T, Worldcom,
Verizon, SBC, BellSouth and Qwest all have sustainable market
positions). Everyone else will likely need to participate in
consolidation in order to avoid Chapter 7 in the next few years.
Please consider what you can do during and beyond the current
balance sheet restructuring to drive this consolidation and
therefore to place your investment in a vehicle with the greatest
likelihood for sustainable value creation.
- If you are a carrier or service provider, seriously consider how
you will participate in the consolidation of the industry.
- Are you positioned to be a consolidator? Can you muster the
currency required to acquire the pieces that would complement
your position and achieve profitability? For carriers, this almost
definitely must be focused on acquiring customers and revenue.
For service providers targeting enterprise customers, this likely
involves acquiring new services and capabilities to improve
competitive position and increase your economies of scope.
- Are you positioned to be a consolidatee? If you aren’t
positioned to acquire others, then have you considered
what you must do to position your company to be acquired
by another to create a sustainable combination? Have you
identified the companies you should be courting? Have you
evaluated your capabilities and organizational structure to
identify changes that could make you more attractive? As
you’re making necessary cost cuts, are you careful to not
lop off pieces that are attractive to acquirers?
- Have you considered redefining yourself as a niche player?
If so, have you identified the practices that need to change to
reduce your costs and focus your activities to achieve a
sustainable position in that niche?
- If you are a vendor selling to carriers or service providers,
have you evaluated how your products will be positioned
in a consolidating industry? When two (or more) companies
combine, will the combined company have good reasons to
choose your technology over those in use by the other
participants in the combination? Should you be developing
capabilities that will specifically ease the integration activities
by the consolidating players?
The ability to cut through the confusion and fear in the industry,
to look through today’s fog to perceive tomorrow’s potential
futures, to logically and sensibly and bravely ask and answer
the critical strategic questions, and to understand your strategic
options and act accordingly has never been more critical.
Let us know if we can help.
+=+=+Need Some Help? +=+=+
TeleChoice helps companies everyday better position their
firms and products for success, whether re-examining
fundamental business strategy or clearly communicating
unique position and value in today’s tough marketplace.
Contact us at info@telechoice.com or visit ( http://www.telechoice.com/)
+=+=+About TeleSparks+=+=+
On occasion, we share with our industry
friends our views on major events and issues in telecom.
We use TeleSparks as the primary vehicle for sharing these
(usually highly opinionated) views, and we welcome your
feedback. Feel free to forward these on to others, but please
copy us on the messages so we have a sense of the extent
of distribution of our views.
TeleSparks is generally authored by Russ McGuire,
TeleChoice Chief Strategy Officer, with input from others
throughout the TeleChoice organization. You may contact
Russ (rmcguire@telechoice.com) or your favorite TeleChoice
contact to share your thoughts on these matters.
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TeleSparks (Archive)