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THE FUTURE OF THE INDUSTRY

Bill for Global Fiber Expansion, Optical and IP Technology, as Well as Problematic Accounting Hits Local & Global Players

Googin, Odlyzko, Isenberg and Klein Explore Why Impact of Optical and IP Technology on Telco's Is Producing Global Economic Train Wreck

pp. 1-2

Find out how to order single copy ($125) or group license ($250) for just THIS MAY issue.

February 25, 2002 -- This combined April May Special issue of the COOK Report on Internet takes an exhaustive look at the train wreck produced by the collision of ten years growth of IP and optical data networks with the circuit switched world. In preparing the second half of this issue we have taken a hard look at the world of fiber, IRUs (both for dark fiber and lambda sales) and, resultant bandwidth over capacity. What we have found tells us that the telecom industry carnage is likely to continue until it burns itself out.

It is immune to attempts at rational policy making and perhaps even to informed judgments by the economic markets because we simply do not have good data broken down by carrier on bandwidth capacity and sales. We have been able to compile some data on our own. The picture this data presents is discouraging because in not knowing precisely what the carriers are selling we simply do not have a fix on bandwidth demand and consequent monetary return to carriers for their huge investment in optical technology. Individual companies may understand the industry's problems but they can hardly afford to be publicly vocal out of fear of depressing their share prices even further.

Looking at how we got into the current mess, we find that between 1985 and 1995 the legacy telco networks were structured for the digital delivery of circuit-switched voice with the purchase of a very expensive SONET based infrastructure. With data representing a small but growing share of traffic, their business model seemed to permit them adequate time to convert their networks and financing to cope with a data dominant future.

Meanwhile, new players with newer networks, therefore lower cost bases, were able to offer less costly transport and connectivity services, which further eroded the revenue base of the incumbents. Notwithstanding, these new players did not grown fast enough to reach economic viability. Most are either bankrupt or tottering on the brink. Legacy ILEC operating expenses are not to going to be able to be rapidly reduced. In the past, as long as operating income was growing, the difference between revenues and expense in the form of earnings would permit the ILECs to try switch to a newer and more cost-effective infrastructure. But today, the difficulty of carrying out such a switch is increasingly obvious.

Andrew Odlyzko three years ago began to explain why the foundation of bandwidth doubling every 90 days on which both the dot com craze and fiber builds of 1996 - 1999 were based was not reality but a myth.

In a similar vein Roxane Googin for about two years has been explaining why the much feared re-integration of telcos into an ILEC led monopoly won't happen either. If Odlyzko delivered the first piece of bad news by telling us we had geared up for a demand that wasn't there, Googin has her own dose of harsh reality to present. The new technology, although itself not yet built into viable companies, is eroding the base on which the circuit-switched telcos operate rendering their balance sheets unsustainable as well. It is our contention that, if we grasp what both Odlyzko and Googin are saying and understand how their conclusions mesh, we will begin to be able to assess the industry's problems. It is our objective to do just this in this issue of the COOK Report.

The shape and economics of telecommunication and the Internet is on the verge of continued massive change despite appearances of consolidation. Amidst the pressure of uncertainty that will make many yearn for just a few new and stabile mega corps, there are too many new pieces of peer to peer and wireless technology emerging to enable the building of an empire that controls everything.

We shall have centralized legacy structures lumbering on for sure. But you will also have technologies that put music photos and video at users fingers tips and with the tools by which to share them an opportunity to use plentiful band width should it be delivered. We see some big picture changes on the way. Asset based telecom will begin to deconstruct the industry into hundreds of thousands of loosely coupled miniature telecom companies. Users of 802.11b nets and peer to peer technologies will weave an independent spheres of telecommunications as the centralized corporatized giants are restructured, we must hope, in more benign and viable forms.

We may not have seen the last of the new technologies either. Just as the web emerged from no where, the creation of peer to peer like "trust" technologies from Safevote http://safevote.com and NMA, http://nma.com, not to mention the newly emerging field of "web services", may well add new demand for services -- both at the edges of the telecom system and from more centralized services that also communicate with vast user communities at the edge.

Part One:

Why the ILECs Are in Trouble

New Technology Has Stood their Business Model on its Head and Is Beginning to Erode their Revenue Base

Googin Asserts that Caught in a Vice Between Shift to Unprofitable Data, Declining Use of Network and Long Depreciation Schedules for Heavy Debt ILECs Will Find Themselves Unable to Pay their Debt

pp. 3 - 14

Googin: What I am suggesting is that we must start by looking at the problem and get people to accept that there is a problem. Do this by studying the manifestations of the problem. And then look for solutions. People are confusing the problem and its manifestations with solutions because they can't stand the tension of not knowing what will happen. But its only after you sit with the uncertainty for a while can you come up with a good solution. Knee jerk solutions based on inadequate understanding won't help.

The Telecom problem is certainly not isolated to the newcomers. To me the fact that people seem to think it is isolated to the newcomers is a bad sign. Why? Because the real Telecom problem is with the incumbents. This makes things even messier because the new green field companies that we were counting on to implement the new technology are themselves damaged. We are in danger of finding ourselves in a situation where the attackers are unable to succeed and where the older players with nonproductive technologies are seen as unable to fail. The attackers are running out of cash before they can get big enough for their operations to scale and pay their operating expenses.

The LECs voice operations on which they depend for their profits have stopped growing and with respect to access lines and minutes of long distance calls terminated to subscribers are shrinking. The LECs tout data growth but income from data services is not enough to offset that lost from more expensive and profitable voice. We simply do not have accurate statistics on total minutes if use of the local voice network. However on page 54 above Andrew Odlyzko points out a fascinating statistic from the United Kingdom - namely that minutes of use of the local network in the form of dial up Internet access are more than 50% of the total as of July 2001.]

A key question to ask is At what point does this snowball beyond the ability of the US government to do anything?

Googin thinks probably this year. It's inevitable, she says. The only uncertainty is the precise timing. They will restructure. It will be ugly. People will loose money. But we will live through it.[snip]

Part Two

Andrew Odlyzko Critiques the Googin Interview

Odlyzko Finds Some Areas of Technical Disagreement -- Cook and Bill Klein Comment

pp. 15 - 20

Googin: Everyone has been playing a little game which now is ending because of IP. Everyone is saying IP will drive prices down by a factor of ten. What people have forgotten about asking is what happens when you own that great big house that you have mortgaged to the moon and all of a sudden your income goes down by 90%.

Odlyzko: Not "[e]veryone is saying IP will drive prices down by a factor of ten."

Part Three

Googin Replies and Incorporates Odlyzko's Voice Versus Cost Data Figures Plugs Revision into Her Framework and Shows the ILECs still Going Broke,

pp. 21-23

Roxane thanks Andrew Odlyzko for elucidation of technical detail that could mitigate against the percipitous decline of the LECs. She then says: "However, the issue at hand is so massive, I doubt it can be understood by reductionist, incremental, thinking that I see in Andrew's critique. While this use of bottoms-up logic forms the well-proven basis of the scientific method, it does not address radical change well. I am therefore approaching the problem from a top-down, holistic viewpoint. I am basically asking what happens when the irresistible force (optical/IP pricing) meets the immovable object (legacy Telco infrastructure, debt, headcount, equipment, copper, and all)".

The points I am making about data boil down to my saying that using the sketchy information available, phone companies are about breaking even on their data revenues on an EBITDA basis, as they receive about 25% of "voice VGE" dollars in on a product that costs about 25% of "voice VGE" dollar to provide. Since EBITDA means earnings BEFORE interest, taxes, depreciation and amortization, this means we have a growing problem if you hold the bonds, or want to sell them any gear. To my best guess, this scenario says that the declining (voice) business has to pay ALL interest, cap-ex and debt principal payments. This would explain the recent RBOC behavior in terms of cap-ex and headcount cuts, with continued declines in margins. [snip]

We can ask all day how fast prices will decline, how fast traffic will move, or what regulators will do, but that hinges individual human behavior, which is inherently non-deterministic. Here, one person's guess is as good as another's.

What is of use to ask is "What happens to a leveraged, legacy, infrastructure when a "killer" technology that costs 1/10th as much to own and operate comes along?" One might say, "it will drive down prices and profits". Then, you start looking for declining prices and profits, which is exactly what we are seeing now. I report what I see, not what I think people will do.

The RBOCs are not healthy today. They are losing their all-valuable access lines, and those pricey access minutes. They are cutting cap-ex and headcount, and are still struggling to meet reduced expectations. I am an analyst's analyst, the one professionals call in to see whether their own analysts are giving them the straight poop. I am paid to know clearly what Wall Street thinks. From this vantage point I can state categorically that these companies are not cutting cap-ex to keep analysts happy, they are cutting it (and their people too) because the base profitability of their business is declining.

Part Four

The Enronization of Telecom, by David Isenberg,

pp. 24-25

I've been thinking about Googin's plaint for a year and a half, off and on. I'm coming to the view that she's seeing two loosely coupled, separable phenomena. The first thing she's seeing is the general malaise in the telecom sector, aggravated by bubble-busting, debt-hiding, other accounting tricks, and not-very-radical technology substitution (e.g., cell phones for land lines, email for phone calls). The second phenomenon, the stranding of network assets because they're rendered obsolete by radically cheaper, fundamentally simpler networks, is potentially much more powerful, but is a longer-term phenomenon that has not yet hit the local telco's fan.

Part Five

Some Thoughts on the Strategic Future of Wireline Services by William Klein

pp. 26 - 30

Klein states: The RBOCs may also face difficulties building a national business customer base. Businesses in general have widely accepted the RBOCs for local voice service, and in some instances for long distance voice service. However for data services, the RBOCs have yet to prove that they are capable of offering much beyond high speed DSL as broadband access in certain metro markets.

Of the long haul incumbents, the greatest question remains AT&T which for reasons unknown to me, is bent on building an IP overbuild network. This, in my opinion, is madness, given their financial flexibility and suite of service offerings today. How they have managed to hang on to their customer base frankly baffles me. Obviously, Armstrong's strategy (for both the consumer and enterprise markets) has failed miserably, causing investors great pains over the past few years. It would be far better for AT&T to bite the bullet and outsource its transport service, as IBM did when it transformed itself from "big iron" towards services. There is absolutely no reason, in my opinion, why AT&T could not buy lambdas from Level 3, Qwest, Williams and others for transport, and focus its capital expenditures on such important areas as innovative applications/services, as well as customer service/retention

Klein also presents an interesting argument against government involvement on behalf of failed networks.

Telcordia Comments on Googin's Analysis

p. 30

A short ILEC Point of view.

Part Six: Capacity Issues

Why the Carriers Are in Even Worse Trouble Than the ILECs

Crushed by Commodity Services, True Competition With No Captive Users, and Huge Over Capacity

Running Headlong Into a Wall of Debt and Unable to Pay

pp. 31- 33

We find that we are trapped between the jaws of huge ununsed capacity and content owners protection of intellectual property at any cost. The politics and economics of our slavish obedience to the "free market" is constricting the availability of bandwidth by placing marketing and policy in the hands of those who expect pay-per-use demand that lives in a walled garden to define and drive the development of broadband services.

Only about 5 or 6 percent of the long haul inter city fiber installed has been lit or will be lit in the foreseeable future. Of the fiber that is lit by 80 wavelength capable boxes only about 8% of what these boxes are capable of is in use. Each incremental wavelength used costs only a few thousand dollars per line card per a couple of dozen boxes to install. Adding ten gigabits to a backbone is relatively trivial and compared to the original cost of building and lighting the incremental cost of doing so is very small. Currently only about four to eight wavelengths per carrier are lit.

Consider demand. Just as the demand for dark fiber IRUs has peaked and fallen off, the demand for wavelengths may now be peaking. Until the fiber owners start publishing verifiable numbers every quarter on how many wavelengths they have "sold" via IRU and via lease there is no credible way to judge changing trends in supply and demand.

Now we can safely assume that with phone network use having peaked there will be little in the way of additional demand there. Assuming that data still doubles every year in North America, you may be able to sell an aggregate of 20 to 25 new lambdas this year to handle carrier data growth. But with fifteen American carriers and six Canadian each with 80 wavelength capable systems you have an easily provisioned supply of more than 1600 lambdas perhaps only 150 of which are lit. The problem is that without complete disclosure from each carrier there is no way of knowing exactly what capacity is actually in use.

Nevertheless our experts are all in agreement that used capacity is only a tiny fraction of what's available. Whether the amount is 4 percent or 12 percent, under current circumstances, makes little difference. In short we likely have at least a five or six year window with current growth before, with the addition of new lambdas, we fill the capacity of the fibers that have been lit. Sales of dark fiber IRUs have basically ended leaving long haul growth dependent on lambdas sales.

But who will buy? Prices are getting cheap enough for enterprise networks to consider using lambdas. But right now even the largest enterprise networks are mostly 155 megabits with a very few 2.5 gigabit links here and there. Most enterprises don't have the means of connecting 2.5 gigabits to a campus let along ten. This leaves other carriers who have a fraction of the capital they once did and whose need for new capacity has slackened.

Bill St Arnaud put it this way: "However, even given a rapid growth in data traffic, I think in the long haul it will be another 3 years before we see any new fibers lit, another 10 years before new fibers are blown in existing conduit and another and 15 years before new conduit is trenched in the ground." The situation seems dire and will determine the fate of many carriers. Policy makers and financial markets are being called on to make judgments but neither policy makers nor financial markets can see the carriers' resources. With the small resources at our command, The COOK Report certainly cannot do a definitive census of the carriers. But even if increased resources could be brought to bear, it is unlikely that carriers would admit to a highly embarrassing situation.

We are stuck with a conundrum where until the debt is wiped off carrier books or until demand skyrockets you have the entire industry embedded in a continued downward spiral that results in more and more bankruptcies. Demand will not skyrocket until the LEC controlled copper based local loop is by passed and either fiber or multi-megabit per second wireless reaches the vast majority of homes and businesses. Even then the demand may still be too easily filled by capacity on hand, until and unless the Canadians can make it possible to extend a wavelength to every home and business.

The technology has indeed overwhelmed the global infrastructure and its installed economic base and rendered it not economically sustainable. Canada looks to be following a strategy of enabling more uses for bandwidth while the United States follows a course of laissez faire in which the market knows best theory is freed to allow the concentration of media and carriers to consolidate an infrastructure duopoly where cable and DSL are the only officially blessed avenues to broadband. The US policy seems likely to be one of handing the market to huge and powerful old technology companies. The funny thing is that if Googin is right those companies will fail.

Describing and Understanding the Overcapacity

Bill St. Arnaud, Andrew Odlyzko and Robert Schult Discuss Details Carrier Networks with Lit Fiber, Prices, and Definitions of IRUs

pp. 34-36

A further difficulty in doing anything other than flying blind in this new wild and wooly telecom market that we were assured needed no regulation is that we don't even have standard terminology.

Consider for example the all important IRU. We asked St Arnaud for help. He told us. An IRU can be for any period of time but traditionally have been 20 years. IRUs started with underseas cables about 50 years ago when the cost of a cable was so prohibitive that a number of carriers were required to partner together to build the cable. The IRU was created by accountants and lawyers so that each participant could treat their portion of the cable as an "asset" with all the rights and privileges of other fixed assets like buildings - e.g the right to sell, depreciate, etc

As far as I know there is no formal legal definition of an IRU today. As such its use has become bastardized over the past years. In general an IRU implied an upfront capital payment. Leases implied annual or monthly payments - but most importantly title to the bandwidth remained with the leaseholder as opposed to IRUs where title is transferred to the IRU purchaser. In these crazy times you will see IRUs with monthly payments and leases with 100% upfront payments.

Odlyzko and St Arnaud Define the Economic Viability of the Newly Constructed Metro and Long Haul Fiber Infrastructure

pp. 37-38

Odlyzko: The general conclusion is that far more fiber was deployed in the long-haul market than was necessary, too much by a factor of at least 10. (The same conclusion does not apply to the metro area, however.) Thus in principle there is no need to deploy any more fiber in long-haul for 5 or more years. What will actually happen, though, is another issue, as the industry will be trading off deployment of new fiber versus deployment of equipment that can use existing fiber more intensively.

St Arnaud: Agree 100%. Not only was too much fiber deployed, but seriously too many fibers were lit with DWDM systems.

Odlyzko: 2. The prospects for the next couple of years are extraordinarily murky. The problem is that we have not just technology trends and the basic growth rate in demand for transmission (which is still high, approaching the approximate 100% per year that still seems to hold on the Internet) to contend with, but also the huge fiber glut (with smaller gluts of routers, etc.), and the dynamics of the financial markets and bankruptcy courts.

Part Seven

A look at a Few of the Carriers ATT, Sprint, MCI and Global Crossing -- A Brief Overview

pp. 39 -41

Chris Byron in the column cited above declared "Time is running out for WorldCom -- Sooner or later, company will almost certainly face liquidation."

"Over the last 19 years, investors have poured more than $100 billion into this rural Mississippi telephone company, and basically, Worldcom has done nothing with the money except buy other phone companies. As a result, the company now sits, as of Sept. 30, 2001, with worthless goodwill on its balance sheet totaling more than $50 billion - so far as I am aware, the biggest such mountain of fake assets in all of corporate America. Add to that some $30 billion of long-term debt, plus $10 billion of unpaid bills and other short-term obligations, and you've pretty much got the whole WorldCom financial picture.

And here's the really interesting thing: Over the course of the 1990s, this $100 billion Mont Blanc of waste has not been able to generate a single dime of net new cash for the business, with all free cash flow coming from stock sales and debt financings (the "Cash Flows From Investing" part of the company's financials). In other words, the second largest telecommunications carrier in the country hasn't actually been a sound business from Day One, but has only seemed to be so because the economy was growing and stock prices were rising."

Part Eight

End of the Global Greenfield Dream

Level 3 Slashes and Burns in a Valiant Effort to Stay Afloat

pp. 42 - 48

In doing this we have drilled down into just what dark fiber IRU sales are and the question of whether they will continue to play a major role in Level 3's revenue stream in the future. We conclude that they and the revenues derived from them will decline significantly. This is already happening. Level 3 does not dispute this and maintains that long term reliance on IRU income was never a part of its business plan to begin with. (Robin Gray Vice President Investor Relations For Level 3 said in an interview with us on February 19th: "We have already seen this decline. So hopefully that is factored in to our in large part already reported 2001 results."

Now it turns out that with the arrival of technology that made wavelength (lambda) sales possible in 2000 and the completion of L3's network in 2001 that lambdas (waves) began to be not only leased but also sold as IRUs. While dark fiber IRU sales already made by Level 3 will provide recurring revenue income, leases of light waves and sale of light waves as five year IRU's are now providing the bulk of Level 3 transport revenue.

Meanwhile as we have explained elsewhere in this issue the new IP optical network fiber based business model that was going to sweep the older circuit switched telcos into the proverbial 'dustbin' of history has itself failed and post Enron bought investigations onto the heads of Qwest, Global Crossing and 360 Networks. Investors are finding out that what they don't know assurances aside WILL hurt them.

Level 3 Vice President of Investor Relations Explains IRU and Revenue Issues in Interview With COOK Report

pp. 49 - 52

Grey: The majority of our historical IRU sales were dark fiber sales. Beginning in 2001, IRUs are both dark fiber and lit services. We view dark fiber IRUs in an opportunistic way. They were a great way to in effect reduce the cost of our network, but it was never strategic to the company.

Part Nine

Roxane Googin's Predictions and the Telecom World

by Andrew Odlyzko

pp. 53 - 58

The conclusion is that the long distance carriers should aim to model themselves after IBM. The most promising area for them is to manage networks that are largely owned by their customers. This will be a huge change, but the IBM example shows that it possible, and also that there is time to do it. The ILECs might be tempted to follow in this same direction, but are less likely to succeed, and may have to resign themselves to operating at lower levels of the networking hierarchy. However, there is likely to be enough opportunity for them even there to thrive.

Conclusion:

If not IRUs & Carrier's Carriers...Then What? Asset Based Telecommunications

pp. 59 - 61

Certainly the outlook for the long haul carriers is grim. A few months ago it was assumed that the LECs would buy them. Now this outcome is regarded as doubtful. Certainly we have come to believe that carrier equities and bonds are not the instruments to be basing one's retirement hopes on. LEC equities and bonds are stronger but the question is by how much. We have come to agree with Googin that the industry may well be headed for bankruptcy across the board.

But Bill St Arnaud suggests a different course saying Googin is absolutely right that the current model for investment is not sustainable. St Arnaud: I have suggested that this lack of sustainability might be the spur to move telecomm to an asset based industry as opposed to a service based industry - much like the computer industry has evolved over the past 20 years. There are companies with fiber resources who are now going into the market of designing and building for customers both condominium and wavelength approaches to the fiber market. In the design and build market a company practicing this business model will light up a dark fiber and take on responsibility of all maintenance etc on behalf of another carrier. The contract says that as the provider (fiber owner) adds additional wavelengths for other carriers to the same lit strand, the price will be reduced over time for the original customers. Also some equipment manufacturer's are moving into this space as well - some announcements pending."

COOK Report: What we have then is a kind of vertical disintegration of the carrier's carrier model which says that you build and light a global behemoth that provisions every kind of imaginable telecom bit service to every kind of customer anywhere in the world. The fiber owner may become an entity similar to a mortgage holding company. This kind of restructured company would maintain the physical resource, and enable others to gain access and to light strands that were contracted for. It would run an accounting operation that would book new customers and send out bills. It would cooperate with engineers and planners in a given area who wanted to work with it in bringing in their own groups of new customers for projects that they defined and sold. It might even have its own small team that, when it found its own customers, could light a few strands directly. Companies specializing in various aspects of network design could partner with the resource holder and then go their separate ways when assets were delivered to the customer.

Postscript

ICANN, Admitting Failure, Nevertheless Trys to Slither Forward into "Reform"

Froomkin Comments that Describing What these People Do is Difficult Given How They Have "Debased the Language"

pp. 62 -66

http://slashdot.org/article.pl?sid=02/02/25/035254

Interview and Article Highlights,

pp.67 - 76 Executive Summary, pp. 77 - 82