Telecoms in Barron's - mentions CLECs
Telecom's Future
Washington-based analysts see industry shifts in the U.S. and
globally
An Interview With Scott Cleland and William Whyman ~ The Precursor
Group is just that: an outfit dedicated to identifying trends and issues in industry,
technology and policy that will have an impact on telecommunications and
technology long before others make the connection. Even better, it's an
independent research boutique, based in Washington, D.C., international in
scope, from which its institutional clients take away not only the most informed
analysis around but also the most unvarnished. Founded by a couple of insiders'
insiders, Cleland and Whyman, Precursor's work offers a perspective missing
from much that passes as research, drawing on the team's experience --
including international communications expert Rudy Baca -- in government and
industry as well as on Wall Street. We caught up with them last week for a
sense of what's on the horizon under the new Administration and where
investors can expect to find opportunities.
-- Sandra Ward
Barron's: What, if anything, changes for telecom policy under this new
Administration and Federal Communications Commission?
Cleland: The Administration will be much more deregulatory, much more
skeptical of industry ownership caps for cable, broadcast and wireless. This is
going to be a consolidation-friendly Administration and an infrastructure-friendly
Administration for both the local telcos, cable, and the wireless providers.
Q: When you say infrastructure friendly, what are you referring to?
Cleland: They are going to want to encourage deployment of the incumbent
cable and telephone communications infrastructure by getting out of the way
and not microregulating.
Q: What else should investors be on the lookout for?
Cleland: The change in the chairmanship of the House Energy and Commerce
Committee. That's a huge shift because the prior chairman was blocking a
majority sentiment to reopen the 1996 Telecom Act. New Chairman [W.J.
"Billy"] Tauzin [Louisiana Republican] wants to reopen the Telecom Act and
modify it in a way that would encourage the Bells to promote deployment of
DSL. There will be House legislation this year. It is going to catch many
investors by surprise. It will pass quite easily, potentially overwhelmingly,
sometime this year. That will change the dynamic, and it will force the Bush
Administration to respond. It will also force the Senate to respond. It is very
difficult for legislation to pass, and so investors should not necessarily expect
the Telecom Act to be revised this year or next. However, they should realize
that the House will pass legislation, which will change the tenor and change the
mood of the sector.
Q: This is an acknowledgment that the Telecom Act of '96 was a failure?
Cleland: It is an acknowledgment that the Telecom Act is seriously troubled.
The Telecom Act has proven to be a lousy investment thesis. Investors
generally interpreted the competitive thrust of it to mean the incumbents would
lose and the insurgents would win. Incumbents have taken almost everything
that the FCC and the CLECs [competitive local exchange carriers] have
thrown at them and they have done just fine. The CLECs, meanwhile, are code
blue.
Q: Is this because of a failure to enforce the act, or a failure of business
models?
Cleland: It was a failure of the economic premise of the Telecom Act. The
Telecom Act assumed that local competition could emerge. The Telecom Act
was supposed to lower prices for consumers. It raised prices for consumers. It
was supposed to encourage innovation. It hasn't, at least with regard to the
incumbents. It was supposed to encourage deployment of advanced services. It
really hasn't accelerated DSL deployment much.
Q: Why is broadband deployment such a problem?
Cleland: Broadband deployment is driven by distance from the existing
network. To understand where deployment will occur you have to understand
the geography of existing deployment. Where is the telephone company's
central offices? Where is cable? Wherever that is, broadband is being deployed.
There are three distinct markets. In the large business market, almost all
companies that want broadband already have it. In the residential market, only
6% of residences have it and about 73% of that is being provided by cable and
about 26% is provided by DSL. Interestingly, the small- and medium-business
market is almost exclusively DSL and it is not getting deployed at all. That's
because small and medium businesses tend not to be downtown, they tend to be
geographically dispersed, and because they are dispersed, they have a very high
demand for broadband. Yet they are the least likely to get it. This is important
and relevant because the small and medium businesses traditionally have been
one of the greatest sources of employment and economic growth.
Q: What's hampering the deployment? Is it simply the Bells refusing to
cooperate with the CLECs?
Cleland: People think broadband deployment should just happen because they
have been hearing that convergence is wonderful and convergence is a good
investment theme.
Whyman: DSL costs a lot more, takes a lot more time, and is operationally
more difficult to do. That's on the supply side. On the demand side, there
haven't been a whole lot of great applications out there for which people are
willing to pay. We are talking about price points of $40, $50, $60 a month. What
are the great applications? There aren't a lot that exploit and use broadband.
Most time is spent on communications applications such as instant messaging.
We are not seeing tons of very intensive video conferencing or streaming
media, or things like that. There is no killer ap on the demand side.
Q: Was DSL oversold?
Cleland: Clearly. The Internet and the dot.com phenomenon made people
perceive that broadband was just around the corner. And broadband required a
reconstruction, a re-engineering, of our two basic networks: The phone network
had to be powered up to a higher bandwidth, and the cable network had to go
from one-way to two-way. In many places, the telephone plant and the cable
plant are abysmal. And so -- this is another reason for the industry's hangover
-- in addition to going on a regulatory binge, it went on an investment-banking
binge where an enormous number of lousy business models got funded. Too
many competitors got funded for a high-fixed-cost industry.
Whyman: The cluster of industries around IT [information technology] made up
30% of all U.S. economic growth from 1995-99. They represent roughly 10%
of the economy, yet they contributed three times their size to economic growth.
IT investments rose to 46% of all capital equipment investment by 1999. That
was unsustainable.
Q: Let's get back to the legislation to be introduced this year. What's the
goal?
Cleland: The goal is to spur local telecom investment, to deregulate the local
telcos for data. If there is going to be something that pulls this sector out of its
funk, it will be the Clydesdales that are the Bells. They are going to be the big
horses, the ones that do the major spending and the major deployment. One of
the fallacies in the market that led to the euphoria in the past was that
competitors -- small companies and next-generation carriers -- could carry the
sector. Yet they were generating a minuscule percentage of the overall
revenues. Telecom is the land of the giants. It's scale. We don't have eight or
nine or 10 auto companies or large steel companies or large aluminum
companies. The economics of telecom demands scale. Very few niche players
are going to prevail long term. They don't have the gross-margin capability to
make it work.
Whyman: The whole incentive structure of the Telecom Act is problematic.
Why would one company sell the tools to its competitors to beat it in its own
game? The Bells are being forced to do that by regulatory fiat. Surprise,
surprise, they did it haltingly.
Q: Are you guys completely writing off the CLECs at this point?
Cleland: Yes. As an industry model, the CLECs are not a very sound model.
The standard investment-banking line is that a few will survive. That's because
a few have private investors who will continue to subsidize their lousy business
models. I am highly skeptical of the CLECs.
Q: Let's go back to your point that there is less demand for some services
than is widely assumed and there is no killer ap. What about data traffic?
Cleland: There's a lot of hype about data. We call it datatopia. We don't expect
the data-growth stories, the Cisco data-carrier business or the next-generation
data carriers, to be able to grow at hypergrowth rates. Data growth is what it
is. The market hyped it as being a lot higher and a lot faster than was the case
in reality. For most investors, the conventional wisdom held that data traffic
growth was doubling every three to four months. That would suggest an
800%-1,600% increase in the annual rate of data traffic growth. The problem is
the actual annual growth rate for data traffic is closer to 100%. That's very fast
growth, but it's not the hypergrowth rate of 800%-1,600%.
Q: So who benefits from data traffic at this point?
Cleland: One of the big challenges for data transport going forward is that it
was built upon a not-for-profit model. We forget that the Internet was designed
by the Defense Department to support academic institutions where everybody
paid their own way. It was not a commercial mechanism to sustain itself.
Whyman: We believe in data growth, but data profitability is elusive. No one at
our conference had an answer for how people make money off data. People
have assumed that volume growth is equal to revenue growth. What we are
seeing is a huge increase in volume counterbalanced by equally substantial
drops in pricing. And the only way out of that box is to provide some kind of
differentiated service. But it is going to take a while before that happens.
Q: So where should investors focus?
Cleland: The lesson for investors here is that the system is set up to collect
money at the access point. Companies that have control of the access point to
the customer, whether it be the phone company, the cable company or the
wireless company, are going to be able to capture the value. The people that
are involved in transport, the long-distance companies or the next-generation
data carriers, are in big trouble. The value is migrating to the local access, away
from transport in a big way.
Q: Let's talk about wireless. What about the spectrum scarcity issue?
Cleland: Wireless is one of the most interesting investment issues in the year
ahead as a result of the new Bush Administration. We believe that the current
spectrum caps will be eased substantially later this year. That's a very big deal
for investors.
Q: Explain the spectrum-cap issue, if you would.
Cleland: Right now there is a limitation that no one company can own more
than 45 megaherz of spectrum in a large city, or 55 megaherz in a rural
community. The result is companies that have the most customers have the
least quality because they have the least spectrum per customer to provide. The
caps were designed to create a lot of competitors. However, it has resulted in
sub-optimized use of spectrum. When the spectrum caps are lifted, it will
greatly increase the utility of spectrum and therefore the value of spectrum.
This could be one of the catalysts that help telecom eventually come back.
Q: Is there enough spectrum available?
Cleland: There is clearly a spectrum scarcity. But the first order of the day
needs to be allowing people to more efficiently use the spectrum that exists.
There is a lot of spectrum woefully underutilized by small companies that don't
have the customers.
Q: How does this play out?
Cleland: We think it is a very positive catalyst for the whole wireless sector
because the spectrum is going to be worth more. Smaller companies will most
likely be taken out. Large companies will be worth more because they will have
spectrum more efficiently utilized. There is hidden value in wireless right now.
Q: What are some names to consider?
Cleland: Among the large players, you are looking at Verizon, Cingular, AT&T
Wireless, Sprint PCS, Nextel and VoiceStream. The little guys are everybody
from Alltel, U.S. Cellular, Western Wireless, CenturyTel, Dobson, Rural
Cellular, PowerTel, Arch Communications and Metrocall. We think AT&T
Wireless will be an interesting issue because they will be enjoying the lifting of
the spectrum caps as they get spun off from AT&T and their flexibility will
increase.
Whyman: For all those people who are counting on wireless to be the next thing
that powers Internet applications forward, they better hope that spectrum
shortage gets resolved because it really is a key limiting factor.
Q: Are you referring to 3G?
Cleland: If you don't have enough spectrum, 3G is a spectrum hog. It will chew
up and cannibalize your profitable voice spectrum. Spectrum caps need to be
lifted in order to provide head room for 3G to be deployed.
Q: What about the extra spectrum held by the Department of Defense?
Cleland: The Department of Defense is the holder of most of the spectrum
that people want. I would tell investors not to hold their breath for the Defense
Department to give up choice spectrum. It is not in their interest.
Q: Where does the extra spectrum come from?
Cleland: That's the whole point. There is not a lot of extra spectrum coming
down the pike, and that's why spectrum caps being lifted is so imperative.
Q: Do we need 3G? Companies keep saying that 2.5G is okay by them.
Cleland: The incremental benefit from 3G for the incremental cost is probably
going to be a real drag on 3G deployment. As Bill mentioned earlier, there is not
a killer high-bandwidth wireless application that people are itching to have.
Whyman: Looking at the business model on these things makes me even more
concerned. You are talking about an expensive transmission telecom
subscription and another Internet service subscription. Are people going to be
willing to pay a third charge? There is talk about mobile advertising for mobile
commerce, but that is just far out at this point.
Q: So who's promoting 3G?
Whyman: People point to Europe. But
there it was state-nurtured and state-
funded. And, for example, 1% or less of
Deutsche Telekom's wireless subscribers
have Internet access. If you look at the
advertising side, the total size of the
market in all Europe for advertising is less
than $1 billion.
Q: What does this mean for NTT
DoCoMo and its iMode, which is based
on the 3G standard?
Cleland: We question whether or not that
will transport well outside of Japan.
Q: Elaborate, please.
Whyman: DoCoMo's iMode is a completely different technical standard than
what AT&T is using and certainly what is being used in Europe with the GSM
families. Like so many things, Japan is Japan specific. We are not saying iMode
is not great, but it is hard to transplant out of Japan, based on technical content,
the regulatory protection that exists, and a bunch of highly specific cultural
factors that drive that market.
Q: What are your thoughts on cable here?
Cleland: The D.C. Circuit Court lifting the FCC's ownership limits recently
was a very positive development for cable and it could create an atmosphere of
consolidation around the industry. That's a positive. Cable, however, has two big
problems: It doesn't know what its cable broadband business model is and it
doesn't know what its legal classification for regulatory purposes is. The cable
industry knew it could make a ton of money if it kept totally closed, but for
antitrust and other political reasons the cable companies have to allow open
access. The question for them is on what terms, and how quickly they open up.
The second big uncertainty cable faces is one of legal definition. Cable does not
want to be regulated at all for its next-generation services. It has avoided any
regulatory classification so far. But there is a Supreme Court case next year
that is going to cause problems for cable in the sense the court may decide
whether cable is really a telecom common carrier, a less-regulated cable
service or an unregulated information service. Those are big questions. They
are going to have to be answered in the year ahead. But make no mistake about
it, this Administration and this FCC can be expected to be quite cable friendly.
So it's a positive outlook for cable with some very nagging concerns about how
they make money with broadband and how they eventually will be regulated, or
not regulated.
Q: What areas in telecom are investors overlooking?
Cleland: Mexico's telecoms deserve a fresh look. Mexico has the
fastest-growing and second-largest telecom market in Latin America. The
election of Vicente Fox and a landmark telecom regulatory settlement between
Mexico's telecoms have really changed the dynamic there for the positive from
what used to be highly uncertain and highly problematic. They had privatized
but not organized themselves for the private market. Also, they settled some
longstanding feuds between the incumbent and the competitor last fall. And
they strengthened the referee, which is Cofetel, the regulator.
Q: What are some names?
Cleland: Telmex is the incumbent and is 9%-owned by SBC. Avantel,
45%-owned by WorldCom. Alestra, 49%-owned by AT&T. Axtel, about 27%
owned by Bell Canada. Then there is Grupo Iusacell, which is one-third owned
by Verizon, and Vodafone announced in January it will acquire 34.5%, as well.
There is also Pegaso, which is backed by Leap Wireless and Sprint.
Q: What else should investors focus on globally?
Cleland: There are some other global stories that are important, but from a
negative standpoint. One is the United Kingdom, the country that started the
whole telecom competitive deregulatory trend more than 20 years ago, is in the
middle of a 180-degree turn back towards heavy regulation.
Q: What's driving that?
Cleland: The Blair government is getting squeamish about deregulation and
privatization. It is significant because the world is following the U.K.'s lead.
This is a very powerful early precursor for global telecom investors. Essentially,
the Blair government has a more regulatory philosophy than the Thatcher
government that started all this. We are seeing legislation being drafted that will
create a much bigger bureaucracy with much greater powers to oversee the
U.K. market. All the signals we are seeing is it is not a deregulatory and not
pro-competitive environment. It is going back to the old style of heavy
regulation.
Q: Didn't you just put out a report on "privacy" standards in Europe?
Cleland: Yes. We are suggesting that pan-regional privacy regulations in
Europe may slow the rollout of location-based applications. In the worst case,
privacy regulations being considered in Europe could thwart development of
software in devices and networks, fragment the market, and hinder global
growth of m-commerce. Use of personal data is the basis of lots of
location-based mobile-communications applications. So European providers like
Vodafone, Nokia and T-Online could be hurt by privacy standards that limit
their ability to deploy location-based services. And it may be another setback
for 3G if location-based services are restricted. Also, a privacy directive by the
U.K.'s Data Protection Commission suggesting all advertising based on location
and purchase tracking patterns be banned throughout the European Union if
adopted as a standard could wind up prohibiting software development and
dumbing down technology for devices and networks. This has negative
implications for Alcatel, Nokia and Ericsson. U.S. mobile providers, in contrast,
are required by the FCC to incorporate location monitoring and reporting
capability by the fourth quarter. And U.S. providers of m-commerce services
like Verizon, Motorola and AOL Time Warner could benefit from the flexibility
of the U.S.'s currently less rigid privacy standards.
Q: What else worries you on the international front?
Cleland: Many investors may be excited about the China market given that
China is now entering the World Trade Organization. We would caution people
to be very careful because while China may have promised a lot on paper, they
are not doing the things necessary in their actions to make telecom investment
in China a good deal.
Q: Thanks, Scott. Thanks, Bill.
News 
Market Data 
Discover 
