The Telecommunications Act of 1996--then and now

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A Hot Sector Burns Out

By Peter S. Goodman, Washington Post Staff Writer

Wednesday, February 28, 2001; 3:03 AM

Four years ago, Wall Street handed Teligent Inc. $125 million to begin beaming telephone calls and computer data over the airwaves into office buildings. The Vienna start-up had yet to sell its service to anyone. But it had plans for a thing called the Internet, and in those days that was enough.

Today, Teligent and scores of other telecommunications start-ups spawned by the deregulation of the industry are on the verge of extinction, their executives working feverishly to pry cash from markets that have gone tight. Investors are withholding their money, spooked by the enormous cost and complexity of rolling out telephone and Internet services.

As the start-ups disintegrate, their troubles are spreading to companies that count them as customers, moving along the production chain in a downward spiral of pain. Once indomitable enterprises such as Cisco Systems Inc. and Nortel Networks Corp. that build the parts for communications networks have faltered as demand for their products slows. Those digging up streets to bury fiber-optic cables to carry the data traffic have suffered amid fears they have finally put more down than they can fill.

For a telecommunications world once characterized by euphoria and upward momentum, the past year has delivered a sobering dose of stagnation and gravity. Talk of initial public offerings and stock options has been replaced by earnings disappointments, layoffs and whispers of bankruptcy.

“It’s really bad,” said Jack Biddle, general partner at Novak Biddle, a venture-capital firm in Tysons Corner. “A lot of companies are going to fail. A lot of people are going to lose their jobs.”

Still, many telecommunications executives have come to regard the ongoing shakeout as a necessary if ugly phase of recovery. Easy financing produced more companies than the market can sustain, and more technological wizardry than the world can consume. Only through elimination and consolidation will a more sustainable order emerge, one that could leave the survivors stronger.

“Those that cannot get more financing will fall away,” said Alex J. Mandl, Teligent’s chairman and chief executive. “There will be a cleansing process, if you will, which is the natural cycle of business.”

The excesses of recent years—the torrents of venture capital and astronomical stock market valuations—were propelled by unrealistic expectations, but the basic foundations of growth remain sound. Demand for high-speed Internet and wireless communications is still powerful. The spread of such links can be expected to spur a new generation of services and a new round of consumption.

Some think the market already has overreacted to the slowing of growth, creating considerable values. The Carlyle Group has raised $3.9 billion for a new buyout fund with plans to invest 25 percent of that money in telecommunications companies.

Peter Barris, managing general partner of venture-capital firm New Enterprise Associates, is sitting on more than $2 billion raised from big institutions. His firm plans to invest much of the money in young technology companies, including telecommunications.

“We’re going through what I would term a hiccup,” Barris said. “It may be a big hiccup, but it’s still a hiccup on what will continue to be an up-and-to-the-right trend.”

Though investment capital remains tight, those who control it say the shakeout is creating conditions in which enduring businesses can again be built.

“If you’re starting a company, this is the best time to do it, because you can hire good people at reasonable wages and your competition won’t get funded,” Biddle said. “A year ago, you had to pay through the nose if you could find people at all.”

Still, a winnowing process is unlikely to fix all that ails telecommunications. Former industry titans such as AT&T Corp., WorldCom Inc. and Sprint Corp., the nation’s three largest long-distance companies, have plummeted as new entrants carve deeply into their core businesses.

AT&T last year announced plans to break itself into four pieces to try to draw Wall Street’s attention away from its eroding long-distance revenue and toward its fast-growing wireless and Internet businesses. WorldCom announced a less radical restructuring in which it will sell shares to track the ailing fortunes of its residential long-distance business.

A larger telecommunications recovery may depend on how quickly companies are able to roll out high-speed Internet services. Only as more homes and offices get high-speed Internet links will the cables beneath the pavement fill with data, increasing demand for the networks and the equipment needed to build them, while creating incentives for investors to seed the next crops of innovations.

Many of the companies erecting the high-speed links to the Internet are stumbling. The “last mile” connection between homes and offices and the Internet remains more blueprint than reality. About half of the nation’s 104 million households have computers at all, and only about 5 percent have high-speed Internet service, according to the Yankee Group, a market-research firm.

As Wall Street poured hundreds of billions of dollars into telecommunications companies in recent years, the expected spread of the high-speed Internet was at the center of its growth visions. The new “broadband” Internet links would enable delivery of music, video, interactive games and other data-rich applications, creating an upward spiral of wealth-creation in the telecommunications industry and the larger technology world.

Internet service providers such as America Online Inc. would collect new customers, sharing profits with companies such as WorldCom that carry computer data around the world, and elevating demand for network equipment. Consumers and businesses would have new reasons to buy faster computers from Dell Computer Corp. and Gateway Inc., elevating demand for chips churned out by Intel Corp. and software from Microsoft Corp. Freed from slow dial-up connections, consumers would be more inclined to buy digital cameras to trade photos over the Internet.

Much of this has already happened, of course. By traditional standards, telecommunications and the larger technology domain remain in robust shape, with many goods and services still growing at healthy rates. But in the logic of the telecommunications boom, healthy growth is not enough—sky-high stock valuations were predicated on the assumption of spectacular, accelerating growth. For those who bought into this view, even a modest slowdown amounts to a cataclysm, one that has dried up capital for many start-ups and whacked stock prices to mere fractions of their former worth.

Prices Are Driven Down

As the reality sinks in that the rollout of the high-speed Internet is likely to be a longer, slower slog, the ripple effects that lifted so many companies in the technology production chain are now working in reverse, erasing paper wealth with each new sign of a slowdown.

Some say high-speed Internet links are being constricted by the enduring control of the former monopoly Bell telephone companies over all but a small fraction of the wires reaching homes and offices. Competitors argue that the federal government has failed to force the former Bells to share their networks. The ex-Bells themselves argue that a surfeit of federal rules is to blame. Wireless telephone companies aim to provide high-speed Internet links, but federal authorities have yet to allocate the needed frequencies, many of which are controlled by the Pentagon.

The policy debate will now play out in a new climate. The Federal Communications Commission has a new Republican chairman, Michael Powell, son of Secretary of State Colin Powell, who has called for streamlining regulations. In Congress, the new chairman of the House Commerce Committee, Rep. W.J. “Billy” Tauzin (R-La.), has vowed to slash regulations and remove remaining strictures on the former Bell companies.

The boom-and-bust cycle that has defined telecommunications in recent years was itself the product of the regulatory climate. Five years ago, Congress deregulated the industry with the Telecommunications Act of 1996. The law allowed the former Bell companies to compete for long-distance service, provided they opened their local telephone markets to competition. It spurred an intense speculative wave, unleashing a crop of new competitors. The start-ups used a multitude of technologies to bypass the former Bells and sell telephone and Internet services, mostly to businesses.

“There was virtually unlimited capital for anybody who had a headline that said ‘Telecom plan,’‚” said Mandl, the Teligent chief executive. “People chased after you with dollars in their hands.”

The enormous flows of capital produced an oversupply that could not be sustained. Too many companies were doing the same thing, particularly in the long-distance business. Hundreds of thousands of miles of cables went down in anticipation of an insatiable demand for Internet transmission capacity.

Scott Cleland, an analyst with the Precursor Group in Washington, said investors operated on the flawed assumption that if more traffic coursed though the networks, the companies that operate those networks would see increased profits. But excessive competition has forced prices so low that no one can profit—not even the player with the greatest market share, UUNet, WorldCom’s Internet subsidiary.

Covad Communications Inc., a Silicon Valley start-up, was a quintessential product of the investment surge. The company sells high-speed Internet links using digital subscriber lines, or DSL, a technology that rides over telephone lines. It raised $8.5 million in venture capital in July 1997 with plans to roll out service in San Francisco.

The company’s founders assumed they would need to demonstrate demand for DSL and their ability to deploy it before they could raise more money and expand. But investment bankers descended with plans for acceleration even before the launch. The following January, Covad sold $135 million in high-yield bonds, capturing cash to begin service in six markets.

“We raised that money when we had 50 lines in service, 42 people in the company and $25,000 in cumulative revenue in the company’s history to roll out this embryonic business,” said Chuck McMinn, one of the founders and now Covad’s chairman. “We didn’t have to prove there was a market.”

There was a market. In the years since, Covad has been deploying DSL at full throttle. Its stock soared. But many of its customers were fledgling Internet service providers who were themselves starved on cut-rate prices as the capital markets sent new competitors onto an already crowded field.

Many have since proven unable to pay their bills, a factor that has contributed to Covad’s stunning plunge in recent months. In the last year, Covad stock was down more than 95 percent.

Covad also encountered great difficulty in gaining the commodity it needs most to sell its service—local telephone lines from the former Bell companies. Similar problems have plagued Covad’s DSL upstart brethren, with their stocks down by a similar margin. Some blame federal authorities for failing to ensure that new entrants would have reliable access to the networks controlled by the former Bells.

“The collapse of the independent DSL providers is primarily attributable to the failure of government,” said Reed Hundt, a former chairman of the Federal Communications Commission.

The larger telecommunications unraveling is also the result of a now-abandoned market mentality that indiscriminately funded seemingly any company focused on the Internet. Investors gambled on the notion that the Internet would eventually be carved into winner-take-all markets. Whoever got big first, whatever the expense, would eventually harvest unfathomable profits. Huge losses were merely stages on the way to the promised land. The only sin was aiming for profitability too soon.

“In some ways, we all got greedy,” said Patty Abramson, managing director of the District-based Women’s Growth Capital Fund, a $30 million venture fund launched at the end of 1998 that invested 70 percent of its cash in technology companies. “We saw that there were some very fast-growing companies and it was . . . who could be first to market, and the way to do it was to hire a lot of people and put a lot of money into building the brand.”

Brutal Capital

Teligent was so focused on pleasing the markets that it effectively compromised its core business and became a sales agent for its stock. The company needed a high-flying stock because that was the admission price to the capital markets, and it needed cash to complete the construction job. A high stock price also supplied currency to buy other companies, accelerating the drive for size. Not least, the stock price affected Teligent’s ability to attract and retain employees in a tight labor market.

After raising nearly $2 billion privately, Teligent went public in the fall of 1997. Over the next three years it built its network, spending about $300 million a year. Today, it serves customers in about 4,200 office buildings.

But the steps Teligent took to get big delayed profitability. Its business model was designed to use its own facilities to beam signals into offices, but the company began reselling service over Bell lines in buildings where it lacked a presence. That increased its customer-growth numbers and pleased Wall Street by nearly doubling its revenue, but the costs outweighed the benefits: Reselling was a very low-margin business.

“We did that because we wanted to reach certain revenue targets and keep the momentum,” said Mandl, the chief executive. “It was about giving the market what it wanted at the time. . . .

‘How many new buildings are you in? How many new markets are you going to open up?’ Those were the big questions we heard.”

As the formidable costs of building networks emerged along with the distant horizons of profitability, the markets reacted vengefully: They shut down the arteries of finance. Those without cash in hand are today in grave peril.

According to a survey by UBS Warburg, about 40 percent of the competitive carriers will run out of money sometime this year. That, combined with evidence of an overall slowdown in economic growth and attendant cuts in technology spending, has lopped projected revenue off balance sheets throughout the telecommunications business.

Amid the rout some see a process that will restore the old laws of mathematics, replacing talk of a new economy with a kind of new realism. Covad’s slimmed-down plans are aimed at generating positive cash flow by next year, even as it now struggled to overcome the recent news that it has been logging revenue that never materialized. Teligent no longer resells local phone service but is now focused on squeezing profit out of what it already built.

AT&T and WorldCom have given up talk of turning themselves into full-service providers of the complete assortment of communications services for consumers and business customers. Much to the chagrin of consumer advocates, both companies have said their core businesses will focus on serving lucrative business customers.

Venture capitalists have returned to the longer, more ponderous process that once determined who got funding. “Now, there’s an emphasis on products instead of hype, and greater value on seasoned management,” said John May, managing partner of the New Vantage Group.

Steve Dow, general partner with the venture-capital firm Sevin Rosen Funds, recalled the glut of computer and software companies that materialized with the advent of the personal computer in the 1980s. Many are gone now, but computers and software are in greater abundance than ever.

“Except for the magnitude of the excess we went through the last two years, this doesn’t feel any different from any other cycles,” he said. “This market correction has been long overdue and is incredibly healthy and will get people focused back on building businesses instead of buying lotto tickets, which has been the mindset of people for too long.”

More than two years ago, WinStar Communications, another telecommunications start-up, slowed its growth, missing out on the enormous spike in value enjoyed by its rivals. Now WinStar is one of the few such companies able to attract capital. It secured $1 billion of financing last November.

“The things that are truly speculative have been eliminated,” WinStar chief executive William J. Rouhana Jr. said. “There’s so much less clutter. The things that are real are getting the focus and attention.”

Staff writer Justin Gillis contributed to this report.

-- (Boom@and.bust), February 28, 2001

Answers

According to Doc this is all FCC and Mabell's fault.

-- Maria (anon@ymous.com), February 28, 2001.

And according to Maria, since the FCC is a government agency, they're here to help us, and Ma Bell no longer exists, since the government broke it up some years ago.

-- (@ .), February 28, 2001.

I'm getting angry with my long-distance carrier. I'd like to complain to someone, so would someone tell me what FCC stands for?

-- (I h@te my. phone service), February 28, 2001.

Please no name, find where I said that.

Federal Communications Commission

-- Maria (anon@ymous.com), February 28, 2001.


Thanks Maria.

-- (I h@te my. phone service), February 28, 2001.


There's another aspect to the telecom situation...banks. From The Economist, Oct. 2000

The bigger they are

There are now signs—tentative for the moment, but worrying enough already - that big banks are messing up again. Three problems stand out. The first is that problem loans in America are increasing, even though the economy is still bowling along at a fair rate. The second is that recent turmoil in the capital markets may well have caused difficulties for some of the commercial banks that have been rapidly expanding their investment-banking businesses in recent years. And one reason for this is the third problem: the banks’ huge lending exposures to telecoms firms.

Take the last one first. The worries here involve mainly “concentration risk”—the risk that banks have too many eggs in one basket, and if the telecoms basket breaks, so will the banks. Most, though not all, of these worries are in Europe. But they involve not only European, but also some American banks. Under the aegis of the Financial Stability Forum (FSF), a committee of the great and the good formed after the financial crisis that followed Russia's default in 1998, regulators have started to take a close look at banks' exposure to telecoms. . . .

Moreover, some of the biggest lenders to telecoms companies in Europe are those American banks that have taken lots of risk back home. Chase Manhattan and Bank of America are two that spring to mind. They must be keeping their fingers crossed that their mousetraps really are better, and the mice no bigger than they were.

-- ($@$.$), March 01, 2001.


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