Bad Connection: Telecom woes;from Forbes Part 2
Tele-Trouble
As millions cut home phone service, Bell executives have spent billions looking for new growth. They're still looking.
Capital expenditures and revenue growth are averages based on wireline businesses over the last five years. Sources: Company reports; Morgan Stanley. Images Courtesy of AP/Wide World.
Verizon is the most extreme case of a Bell burning through all its cash just to stay even. By the end of this year the company will have piled up five-year spending of $75 billion sprucing up the networks of its myriad pieces (the former Bell Atlantic, Nynex and GTE). Its revenue will have grown 5% a year in this time, to $68 billion this year, with all of that growth due to an influx of new cellular customers. (Verizon owns 55% of Verizon Wireless and consolidates the subsidiary on its own financial statements.) With all that cash plowed into capital projects, Verizon was reduced to issuing new debt to fund $17 billion in dividend payments. Verizon now creaks under $61 billion in total debt, including the money owned by Wireless. Moody's recently put Verizon on credit watch for possible downgrade from its current A1 rating.
The other major Bells' stories are only slightly better. In the five years between 1998 and the close of this year BellSouth will have put $28 billion into capital expenditures. In return the new investment has let the company increase revenue by 6% a year. SBC will have pumped $52 billion into its core business, to achieve some 2.5% annual growth.
Frederic Salerno, vice chairman of Verizon, counters that the last few years "were a bubble in capital spending ... an aberration," forced by the long-distance push and federal rules that required the company to crack open its network and welcome in competitors. Verizon cut capital spending by 45% to $2.4 billion in the first quarter, though Salerno says it continues to invest in new growth areas. "The loss of access lines is not necessarily a disaster if we are able to do two things," he says. "The first is adding new service to the remaining lines; the second is cutting the cost [of those services]."
are in trouble. They say soon-to-materialize growth in the newer pursuits--everything from long distance to high-speed Web access to wireless to corporate data-networking--will more than offset any losses in local service. SBC's chief financial officer, Randall Stephenson, argues that stagnating long-distance revenue will begin to flow rapidly as the Bells capture more profitable customers and enter more markets (collectively, they have thus far won approval to sell long distance in 15 of their home states, home to a third of the country's population). He also says the Bells' base of 4 million Internet customers will soon turn profitable as the market shakes off its growing pains. In California, after a customer is hooked up, SBC's operating (a.k.a. EBITDA) margin on digital subscriber line (DSL) service is 40%. "I go out to a mature territory, and I see a business I like," he says.
Analysts on Wall Street often get captivated by EBITDA--earnings before interest, taxes, depreciation and amortization. But wise man Warren Buffett says such talk makes him shudder. One of his letters to shareholders asks acerbically, "Does management think the tooth fairy pays for capital expenditures?" This is the essence of the debate over the Bells' investment value: Defending today's revenue levels may require forever spending so much on new technology that they never have much in the way of free cash flow-what Buffett calls "owner's earnings"-with which to pay down debt or pay dividends. Cable television operators have the same problem (see story, p. 107).
Many Bell execs say their biggest weapon against line losses is a growing ability to combine local phone service with wireless, long distance and broadband. BellSouth recently introduced the "Complete Choice" plan in the Southeast, bundling local with cell or Internet service. "It reduced churn [turnover of high-speed Internet customers] by nearly 70%," says BellSouth Chief Financial Officer Ron M. Dykes. "As we go forward in telecom, churn becomes probably the most important financial indicator," he adds, which may be why he won't say just what BellSouth's churn is.
Meanwhile, the Bells, attentive to the risk of credit downgrades, are hacking expenses and capital spending. SBC cut 11,000 employees in the past year, 5.5% of its payroll. It also is consolidating 450 call centers into only 180 to save $700 million annually. Verizon pared 16,000, or 6% of its total, and BellSouth cut 4,500, or 5%.
The Bells can make up for their shrinking core by buying up their beaten-down telecom peers. Rather than continue pouring their cash into their own questionable capital projects, they could try to simply buy growth. Whether to launch a buying binge "is the single biggest strategic issue facing the telecom industry today," says Luiz Carvalho, a wireless industry analyst with Morgan Stanley.
Bankrupt WorldCom has assets on the block at trash-heap prices. Cell phone companies trade for under 20% of their peak market values. VoiceStream, AT&T Wireless, Sprint PCS and Nextel are all cheap enough to fit in a Bell's budget. But the window of opportunity won't be open long. "If the Bells screw around for a couple years," warns one top telecom executive, "they won't have the currency." A still bigger problem: Buying wireless or long-distance customers won't get them off the capital spending treadmill.
Verizon Wireless and Cingular (co-owned by BellSouth and SBC) represent the Bells' one reliable source of revenue growth as their core "wireline" businesses have stagnated. Yet the wireless business has proven a sinkhole for investors, who have had to plow ever more money into expanding capacity, with scant return. The average wireless user talked 50% more in 2001 than in 2000, but paid only 5% more for the privilege. With publicly traded wireless stocks off 70% in the past year, Cingular and Verizon Wireless both had to shelve plans to be spun off to the public.
Ultimately, the lure of buying into growth businesses may prove overwhelming, as the Bells struggle to replace the business that their new competitors are stealing. Leap Wireless, a San Diego-based Qualcomm spinoff, has pioneered the sale of cell phone service designed specifically to replace local phone lines. Leap now has 1.4 million customers in 40 midsize cities, and a full 26% of them have cut the cord entirely, canceling local phone service to go wireless. Its subscriber base grew 207% in the past year, and the portion who drop Bell service is rising as well.
Focusing on 40 lesser markets saves Leap the cost of supporting a nationwide network and competing on crowded turf. Its network now costs less than a penny a minute to operate, the company says. (The industry average is roughly 3 cents, according to Morgan Stanley.) The Leap model makes it possible to charge a flat fee--typically $33 a month--and vastly increase usage. Customers talk on Leap's phones for 20 hours a month, triple the wireless industry average.
It is part of a generational shift to wireless, says Leap's chief executive, Harvey White. "Our demographic is younger, and when people start a household today they simply never bother to get a land line." Leap's business model is being mimicked by half a dozen companies around the country. Qwest offers all-you-can-talk service in Minneapolis and Omaha. Alltel's Boomerang service now serves ten cities, such as Albuquerque and Greensboro, N.C.
Since the Bells own stakes in wireless firms, they get back some of the revenue lost to cord-cutters. But it's a miserable trade. When a Bell customer cuts the cord to go wireless, the company loses about $19 in monthly operating income and picks up only $4 to $6 or so in return, according to Merrill Lynch. That's because the Bells' wireless arms recapture only a fraction of the cord-cutters, and wireless subscribers generate less cash flow to begin with.
Still worse for the Bells than cord-cutting is losing customers to the cable companies. About 1.7 million Americans now get their phone service over cable lines, a hair under 1% of total phone lines. A tiny number, but one that grew 66% last year. In the few markets where cable has been around for over two years, about 20% to 25% of homes tend to sign up, says AT&T. So far Cox and AT&T have been the only major cable companies to aggressively push local telephone service, but the cost of equipment needed to let a homeowner talk is falling rapidly. Even their more cautious rivals expect to begin avid pursuit of phone customers in the next two years.
The Bells had once hoped to thwart their cable adversaries by getting into the business of delivering rival video service, but in the mid-1990s those dreams smacked into obstacles of cost and technology. To counter cable in Net access, the Bells pushed DSL, but even that could ultimately hurt their phone business. DSL is a fat enough pipe to let customers shut off primary lines when they add a modem to the household. The idea is simple: Use an Internet connection to carry a phone call from a home out to the regular phone network. Instead of paying the phone company twice for the same wire, pay once for an Internet connection that carries both voice and data. The only hurdle, a significant one, is to make sure an Internet phone provides a prompt dial tone and rings reliably.
Jeffrey Citron, who founded Island ECN and Datek Online, says he has solved those problems. Citron has plowed $19 million of his own money into Vonage, a company that began offering local service over DSL in April. (It also works with cable modems, cutting the Bells out altogether.) Vonage offers 500 minutes of local and long-distance calling for $20 a month and unlimited service for $40. Taking advantage of a technology called Session Initiation Protocol, the phones use the customer's high-speed Internet connection to carry a call to the Internet, which carries it most of the way to its destination before handing it off to the phone network. Island ECN and Datek Online both hit it big by taking a chunk out of the fat profit margins of Wall Street firms, and Citron sees an opportunity to repeat the feat, this time with the Bells as his target. "The incumbents are ripe for being displaced, and technology has created a naturally disruptive force," he says.
Bell executives dismiss talk of massive erosion in revenue and line growth as scaremongering, and that may comfort the 5.5 million shareholders of Verizon, SBC and BellSouth. But then, similar protestations were lodged by long-distance executives five years ago. Today no one can deny that cellular phones and rampant competition are choking that business to death. Sprint attributed most of its 10% dip in long-distance traffic last quarter to increased cell phone use. AT&T long-distance traffic is expected to drop 25% this year, driven mainly by the relentless advance of wireless. Will local phone service repeat the pattern, becoming the last telecom pillar to crumble?
It's looking mighty wobbly.
--------------------------------------------------------------------------------
< Previous 3 of 3
--------------------------------------------------------------------------------
E-mail story
Send comments Print story
Request a reprint
--------------------------------------------------------------------------------
Market Data 
Markets 
AI
