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Telecommunications Markets Look Past 2003

March 2003
By Henry S. Kenyon

Glimmer of hope shines through the gloom as firms deal with management, capacity issues.

The telecommunications industry will see minimal growth this year in the wake of several large corporate bankruptcies and massive network overcapacity. Major issues such as mismanagement must be addressed to regain the trust of shareholders and government oversight agencies, analysts say. Sales of hardware will lag behind services as disillusionment settles in about the industry’s performance. But a silver lining remains—the continuing growth of services such as broadband and wireless messaging.

A recent report by Gartner Incorporated, a Stamford, Connecticut-based market analysis firm, forecasts continuing low growth for equipment purchases until mid-2004. According to William L. Hahn, a senior analyst at Gartner and co-author of the report 4Q02 Update: IT Telecom Forecast Scenarios, 2002-2004, the industry is inherently robust, but the heady growth of the late 1990s created unrealistic expectations about its ability to generate profits and growth.

With the implosion of the dot-com bubble, the immediate danger is that the remaining large service providers and telephone companies may conclude that their conservatism is justified. If this viewpoint solidifies, companies will probably concentrate on avoiding further pitfalls by focusing on issues such as questionable accounting practices or making sure their chief executives are above reproach, Hahn says. But in doing so, the telecommunications firms would divert attention and funds away from major advances such as broadband Internet services.

Demand for broadband services continues its unabated rise in spite of recent upheavals. “We hear claims of something like 100,000 households a week signing on for either DSL [digital subscriber line] or cable modem service. We’re looking at a very significant penetration of the world’s largest and wealthiest national market in the next few years,” Hahn says.

This growth will have a strong effect on service offerings and influence business consolidations. Hahn warns that 2003 will be a down year from a stock market investor’s perspective, despite steady growth in some sectors. Equipment purchases will be down because of overcapacity, but demand for services continues to grow in North America and most of the world. The only exceptions are regions beset by backward government policies such as those in the heartland of Africa or by economic upheaval as is apparent in Brazil or Argentina.

Hahn sees the industry returning to strong but not spectacular growth by mid-2004. Gartner predicts that this growth will be sparked by a large equipment purchase order by a major telecommunications carrier some time late this year or early in 2004. However, because of overall low equipment sales, the systems purchased this year will be conservative and multipurpose.

Hahn describes the difference as choosing circuit-switched over packet-switched devices. “They will want to have equipment that is flexible. Network architectures that can handle either one, not committing totally to just a next-generation framework or a total broadband deployment scenario,” he says.

The kind of boundary-pushing energy displayed by the industry’s more “disruptive” companies such as Global Crossing will not return until 2004, Hahn predicts. That company paid the price for its tactics, however, and the remaining industry carriers and service providers believe they are vindicated for not shaking up the market, he says. These companies will wait and use their current equipment until the market changes. “They can wait. And when conditions are more ripe, they can pick up again where they left off,” he observes.

However, mismanagement is a more pressing issue than the financial troubles faced by the telecommunications sector, Hahn believes. He notes that the three major companies that filed for bankruptcy protection in 2002 will be emerging from reorganization by mid-2003: Global Crossing, WorldCom and 360 Networks. He warns that a major unresolved issue is how the U.S. government tolerates business failures in the telecommunications sector. “I think one thing you can carry away for sure from the FCC’s [Federal Communications Commission’s] attitude is that it is orders of magnitude more concerned about cessation of operations than about bankruptcy,” he says.

But this approach sends the wrong signal, Hahn contends. These major companies got into trouble by practicing varying degrees of disruptive business tactics such as predatory pricing, he says. But this backfired because it did not return enough profit and brought about their collapse. Now that their debt has been largely wiped away, company officials claim they will not repeat these activities, but Hahn remains skeptical.

Noting that the newly reorganized firms are more capable of undercutting competitors’ prices, Hahn is not convinced that sales representatives will resist the temptation to begin driving the company again at some time in the future. “Because it’s just a little more of a discount and we’ll win the account. Just a little more and then shave, shave, shave, and the whole thing crashes down again,” he maintains.

At that point, he expects the FCC will have an important role in sorting things out. He notes that rules prevent individuals from declaring bankruptcy to avoid paying bills or child support, yet it is possible for a company to repeatedly go into Chapter 11. This is unacceptable in the current business climate. “God forbid one of these players goes in for reorganization a second time. But the laws of the country appear to be that you can just go ahead and do it,” he says.

Instead of being concerned with simply preventing networks from shutting down for government clients like the U.S. Defense Department, Hahn suggests the FCC must act to ensure telecommunications firms conduct themselves in a fiscally sound fashion. Enforcing proper accounting practices is important to prevent the hollow business swaps that brought about the collapse of WorldCom and Global Crossing, he says.

Overcapacity is another major problem haunting the industry. Hahn lays the blame on the “bandwidth prophets” of the late 1990s who pushed for laying more fiber optic cable than was commercially viable. Citing the example of submarine telecommunications lines recently laid across the Atlantic and Pacific oceans, he explains that these scenarios are easier to measure than landline use. “Even though they weren’t laying as many individual fibers [as landlines], it was still obvious that there just wasn’t going to be enough of any conceivable application to fill these pipes. And yet all you ever heard from these guys was, ‘If you build it, they will come,’” he says.

The question that went unanswered was what kind of profit-sustaining and bandwidth-eating applications would people use to fill all the new lines. “Sure enough, we had bandwidth growth announcements of 2,500 percent year after year. What could fill that up? It was millions of simultaneous telephone calls 24/7—which nobody’s going to do. Who’s going to be piping video across the Atlantic?” he asks.

When the bottom fell out of the market, the bandwidth prophets left enterprises and Internet service providers with the excess capacity. Everything about these deals was wrong, Hahn says. Capacity was being sold for 25 years when conservative estimates saw per-gigabit prices dropping by 50 percent per year. The providers were trying to make customers pay steady up front rates in order to pay the vendors who laid the cables. “They had to pay them the full price. And the price to cross an ocean, to bury a cable 12 feet under the ocean floor is the same whether it carries a gigabit or a terabit. The increased capacity does not get you anything. It still costs about $1 billion to cross the ocean,” Hahn explains.

The combination of fixed equipment costs and precipitously dropping capacity values was a recipe for disaster. “Nobody bothered to sort this out. They wanted to stay at the top of the chain and just sell capacity and let someone else worry about what the application actually was,” he adds. 

But a silver lining exists underneath the recent chaos. It is the continuing and steady growth of broadband subscriptions. The continuing expansion of broadband services is even more impressive because the only real advantage of DSL is a faster download, Hahn observes. But a critical mass of users and services is necessary to fill the empty fiber optic lines. To do that, content must be created to operate at more than 64 kilobits per second—speeds similar to those of video.

But filling those data pipes will be a challenge. Submarine cables usually carry about eight strands of fiber optic line, but landlines can carry up to 800. Less than 10 percent of available fiber optic pipes are in use, he says.

The report also suggests changes in the way the U.S. government regulates bundling and last-mile issues. Noting that the existing unbundled element regime is overcomplicated, Hahn explains that a local loop consists of 400 individual parts, each of which is either leased or charged. Further confusion is sown by some states adding discounts on top of federal government mandates. However, he believes the government is beginning to lean away from this complex regulatory regime.

Gartner’s suggestion involves creating a flexible regulation framework, freeing the government to regulate specific services instead of the carrier. Regarding last-mile issues in connection to local loops, Hahn explains that the government can do what it did 20 years ago when it deregulated telephone wires in households and businesses.

A deregulated zone could be extended outside a property by several hundred yards—not exactly the last mile, but important enough, he contends. This piece of wire or fiber would then belong to the end users, and the telephone companies would write off its cost. Every collection of households and businesses, housing developments, apartment buildings and office parks would have an aggregation point where the privately owned fiber would connect to a service provider’s network. “We think that’s one solution that would apply. Not everywhere but in a lot of suburban zones,” he says.

In less developed areas, a regime similar to what currently exists across the entire United States could exist where a regulated carrier provides service. However, the goal is to give the government a variety of service choices for a given region based on the potential of the area as opposed to the financial organization of the carrier.

Wireless substitution for traditional landline systems will continue in 2003. Growth also will be evident in many other parts of the world such as Europe, Asia and the Middle East. Hahn notes that cellular use continues to rise in developing nations without extensive landline networks. While the technology in use is not cutting-edge, he believes its economic and social impact is huge. However, wireline access is still necessary for effective Internet access, and it will have to go through local telephone companies, which are often inefficient state-owned enterprises.

In the developed world, wireless services such as text and multimedia messaging for cellular telephones are growing, highly popular applications. Ironically, these services do not generate much revenue, but attract users, Hahn observes. This is an important distinction because wireless use is divided between the generations, with younger people being more accustomed to the Internet and wireless devices than their parents. A major question facing manufacturers and service providers is what services will these youngsters want when they become earners and purchasers, he says.

But wireless services also took some hits in the past year. In Europe, many carriers are recovering from their investments in third-generation (3G) spectrum licenses, but 3G has not lived up to its promise, Hahn says. While there was a rush to purchase frequency, there is a lack of applications. “What are people going to actually do with it that makes you money and makes them want to have it?” he asks.

Hahn notes that many Western European governments are now considering forgiving the costs of some of these spectrum bids—which ran up to $100 million for a license—and permitting service providers to build their networks together to save costs. But not all European nations bid out their spectrum at high cost. Sweden offered its licenses at relatively modest prices by awarding them to the most qualified applicants instead of the highest bidder. He describes this as the shepherd’s choice. “You can kill the sheep and have meat today. But you need to think long-term. If you take care of the sheep, you don’t get much right now, but you get wool every year. That’s what a good shepherd does. You give away the licenses if you have to,” he explains.

Additional information on Gartner Incorporated is available on the World Wide Web at  http://www3.gartner.com.