THE TELECOM QUAGMIRE

Recent announcements from a variety of companies (including “Baby Bells” Verizon and Bell South, WorldCom, Cisco Systems and others) confirm what I wrote below in my March issue, and what I have been telling ANYONE who will listen for some time.  That is, there is NO imminent recovery ahead in the telecommunications sector.

            Much was written in the latter stages of 2000 and for much of 2001 about the implosion of one Internet-related company after another.  An industry still in its infancy was overinvested in, by even Middle America.  Banks and other lenders poured limitless amounts of money into companies with virtually no operating history.  The combination led to wild speculation and an industry that got light-years ahead of itself.  Once the frenzy peaked and money started to dry up, Internet concerns began dropping like flies; and with them, investors’ portfolios.

            Yet for all the hand-wringing over the Internet craze, the very similar one that engulfed telecommunications firms received relatively little ink until recent months.  The high-profile bankruptcy filing of former high-flier Global Crossing and the rumored bankruptcies of such luminaries as Lucent Technologies and Bell sibling Qwest are beginning to change things.  Now, wiser folks are slowly realizing that it is the telecommunications industry’s troubles that could still torpedo the broader economy, even as the Internet industry tries to find a few horses to ride up off of its bottom.

            Lost until now amid the somewhat more spectacular blow-ups related to the Internet was that, as an industry, those companies coming up with new “business-to-business” (B2B) applications, on-line shopping, some software concerns, myriad new web sites and more were nothing in size and scope compared to the telecommunications industry.  A great many Internet companies--even those who briefly enjoyed lofty market capitalizations--employed no more than a handful of people.  In contrast, by one account I recently ran across, the telecom industry has already laid off more people than were employed by the Internet companies at their peak!

            Just as the Internet was going to totally transform our lives as both consumers and investors, so too were the increasing breakthroughs in communication technology going to make us all rich (if we invested in the craze) and make life more enjoyable and efficient.  To be sure, products and technologies from cell phones to DSL lines, broadband, and the still-coming “marriage” of telephone, Internet and interactive media/television all in one place are all truly great.  But some products and companies are greater than others.  In these areas, the “creative destruction of capitalism” as once described by the late economist Joseph Schumpeter has been doing its most incredible work; destroying investors and companies who too quickly become obsolete or less competitive.

            And--before the telecom industry manages to find its way out of the current quagmire--the destruction is bound to get worse, rather than better.  Many more companies will end up biting the dust; some of them, companies looked at not too long ago as being safe, conservative places for investors’ money. 

            If it’s any consolation, at least one group of investors saw this meltdown coming and beat an early retreat from the sector and their own company’s shares: company insiders.   As the March 1 Wall Street Journal reported, “A review of trades reported to regulators (for the last year) shows that selling was rife throughout the telecommunications sector, which soared in the bull market bubble, only to tumble over the past two years, wrecking the portfolios of many investors who didn’t sell as fast as some insiders.”  The heaviest selling was reported to have come from executives and board members at Qwest, McLeod USA, Exodus Communications and Allegiance Telecom.

WIRELESS WOES

            This creative destruction has arguably performed its most devastating work on the several wireless companies, as well as those serving them with handsets, equipment, towers and the like.  “After five years of strong growth,” wrote Andrew Bary in the February 18 edition of Barron’s, “the wireless industry has put cellular phones in the hands of 130 million Americans--nearly half the population.  But it is under fire from an increasingly unforgiving Wall Street because its growth hasn’t generated substantial earnings for the six players in the brutally competitive field.”

            Now, I can be cynical or say “I told you so” and ask those who poured money into these companies’ shares what they could possibly have been thinking; but I’ll be charitable.  Let’s forget the past for a moment, and look at the present reality for companies such as Sprint PCS, AT&T Wireless and Nextel in particular: That reality is that the wireless market has reached a phase now described by some as “mature” with incredible speed.  True, so-called “saturation” numbers have not been reached here to the same extent as Europe, where slightly more than 60 percent of the population has a cell phone.  But clearly, net new subscriber growth has slowed to a trickle for U.S. companies.   And profitability for the industry as a whole may be far in the future; and then, only for the couple or so who manage to survive.

            And, survival will be tough in this current environment, which if anything is getting worse for wireless companies.  Making things look even gloomier is the fact that investors have finally decided they want to see profits, rather than just subscriber and revenue growth that might one day lead to profits.    Seeing none, they have punished share prices across the board of wireless companies, as well as anything connected to them.   This has helped to make a bad situation worse; after all, shaky companies with weak share prices, and downgraded debt in a maturing industry are going to have a heck of a time raising money if they need to do so to merely keep their doors open until better days come.

            But will we see better days soon?  As Bary wrote further along in his article, “Suddenly, a once-fawning Street is talking about the bear case for wireless: It’s a maturing industry, laden with heavy capital expenditures, excessive marketing costs, fragmented technology standards, high customer turnover and little pricing power. . .The big fear is that wireless will follow the downward path of the long-distance phone industry without (first, at least) generating the profits that business once enjoyed.”

            “BABY BELLS” NOT IMMUNE

            As some of the early troubles in the industry began to surface last year, the so-called Baby Bells, in relative terms, held their own with the exception of Qwest Communications.  That Denver-based company saw its shares fall during most of the last year right in line with other of the telecom bust’s biggest losers.  But in the case of Verizon, SBC Communications and Bell South, a delayed reaction of sorts has seemed to set in, and even these companies have been tottering as investors wonder whether even they are going to be in as good a shape down the road.  All three of these stocks are now locked in downtrends of their own of one magnitude or another, and are trying desperately to keep from making new lows.

            Back in November 12th’s edition of Business Week, Charles Haddad started off by describing how these goliaths of the industry had held up at least for a while.  “Just a few months back,” he penned, “the Bell phone companies were the aircraft carriers riding calm above the roiling seas of the telecom market. . .All the while, the Bells cranked out profits, revenues steadily increased, and their stocks held up. . .

            “Now they’re starting to list,” he went on.  “With the release of their third-quarter financial reports, Bell South, Verizon, Qwest and SBC have shown that they are more vulnerable than many had expected.  Their revenue growth is slowing, profits are declining sharply, and their stocks, as a group, are down 25% from their peak last year.  Most worrisome, their core businesses, which were supposed to be so steady, are starting to shrink. . .”

            Haddad discussed this at some length; talking about how it’s not just the slower economy that was hurting the Bells, but even that “creative destruction” that I referred to earlier.  “What’s happening is that, after 100 years of steady growth, the local phone business is going through a sea change.  New technologies--wireless phones, e-mail, instant messaging, and cable modems--are siphoning business off of the old telephone networks.”

            All of this does not bode well for those thinking it might be time to bottom fish even among these most “stable” of telecoms.  Bell South recently halved its earnings growth targets for 2002, and simultaneously announced that it would cut a half a billion dollars from this year’s planned capital spending budget.  SBC and Verizon are also tightening their belts.  SBC, at least, seems to have come up with a creative way to make its bottom line look a bit better; according to a story in the March 7 issue of The Wall Street Journal, it has inflated its “assumptions” about how much it would earn from pension assets in order to bolster its stated earnings.  Never mind the fact that SBC’s fund investments fell by seven percent. 

            RIPPLE EFFECT

            Those companies making various gizmos and offering a variety of services to the “main” players in telecommunications are suffering along, both as capital budgets get slashed, and as the overall industry continues to deal with a huge overcapacity problem. 

            Much has been written about the wonders of modern fiber optic networks.   A number of companies began producing this high-tech glass in copious quantities, on the belief that a surge in borrowing and spending would lead to a surge in use.  But it hasn’t happened.  According to The New York Times, companies over the last two years have spent (much of it borrowed money) a staggering $35 billion worldwide to lay 100 million miles of optical fiber for broadband networks.  Only a small fraction of it has been “lit” so far.  The trouble is, debts surrounding some of this fiber and related products and services are still there--and are coming due.

            Fiber optics were an area that a couple companies bet heavily on.   The venerable Corning (the second most important company to my own family’s history, after the late Endicott-Johnson Shoe Company) used its skills in glass to produce more than its share of the above-referenced 100 million miles.  The trouble for them is that, in retrospect, they might have bet a little too heavily on fiber optics, and neglected other, more stable areas of their business.  As a result, Corning’s finances and business prospects have deteriorated, and a chart of the company’s stock price over the last couple years could easily result in confusing Corning with one of the many Internet blow-outs.

            In the March 4 issue of the Financial Times, Paul Abrahams wrote about others who will continue feeling the crunch of weak spending, especially in the wireless area.  Texas Instruments is warning the worst is not over yet.  Companies such as Nortel Networks, Cisco and Lucent will continue to plod along with shrinking revenues and, perhaps, with every day another test at whether Chapter 11 can be held off.

BIGGER RIPPLES STILL AHEAD FOR THE MARKETS/ECONOMY?

            Where many Internet stocks and companies were concerned, the fallout of these firms’ failures was relatively confined.  Most of these companies when they started went the once white-hot IPO route; thus, they were financed entirely, or nearly so, by equity.  So, when they went belly-up, it was private shareholders who lost.  Further, as I said at the beginning of this piece, small numbers of employees were involved.

            The stakes are much bigger as the telecommunications industry continues its painful contraction.    The Baby Bells alone have already been responsible for tens of thousands of layoffs; and judging from the universally bearish prognostications still being made for the months ahead, it’s likely that thousands more will still lose their jobs.  Jobs have been lost at networking companies, equipment makers like TI and Cisco, and elsewhere.  While I am not privy at the moment to a reliable number of the grand total to date, one analyst I recently read a report from suggested the total number of layoffs that can be blamed on the telecom bust is already over 340,000 (I do know that some 65,000 of those are courtesy of Lucent Technologies alone.)

            That’s that many more, folks, who probably still don’t have a job, won’t be spending as much either way to help the economy “recover,” etc.  

            An even bigger worry, though, is what the telecom contraction has already done to the financial markets--and what it might still do. 

            $500 BILLION was spent, more or less, in the giddy build-up of communications networks of all kinds over the last few years.  Much of that money came from venture capitalists, other private risk-takers--and lots of well-known financial institutions.  Already, a number of telecom outfits are grappling with multi-billion dollar write-downs of vanishing “good will,” equipment that was cutting edge when built but now is on the shelf and obsolete, and other one-time “assets.”  The trouble is, the debts are still there.

            Qwest has made considerable news of late over its inability to get short-term financing on the easy terms commonplace a mere couple years ago.  Both Standard and Poor’s and Fitch recently downgraded the company’s debt.  At the same time, some $3.2 billion of commercial paper (effectively, short-term, unsecured IOU’s typically bought by money market funds and various others) came due--and the holders refused to roll over the paper.  As a result, Qwest had to tap a bank credit line and, as I write this, it has recently sold $1.5 billion in new bonds to raise additional money to keep from going into default on its total $25 billion in debt any sooner than it probably will down the road.

            Some of you know that Lucent was the target of regular rumors late last year that it was about to file for Chapter 11 bankruptcy protection.  The company has been bleeding money due to mounting losses, and its share price as well is a fraction of its former highs.  Fears of long-term liquidity and the very viability of the company continue.

            One of the more incredible microcosms of what is being faced by the entire sector--and an often entertaining one at that--is the saga of WorldCom.  As did Cisco Systems in its corner of the technology/telecom equipment universe, the upstart WorldCom used lots of debt, an inflated share price and the bravado of its chairman, Bernie Ebbers, to go on a buying spree.  The goal, of course, was to become one of the big fish in the pond.  But as the telecom bubble burst, the realization set in that the company had paid far too much for its many acquisitions (and will likely be writing off some $20 billion in assets soon) and, therefore, WorldCom’s own share price was inflated.   After peaking at over $170 per share in 1999, WCOM shares are now pegged at under $10.

            All this misery--and fears of more bankruptcies to come--have put would-be lenders in a foul mood.  Many companies in this sector must continue to find ways to raise capital to roll over existing debt, and to merely survive in some cases.  That is now much harder to do, as Qwest has found out.  Higher interest rates will be paid down the road.  Commercial paper markets will continue to dry up, and those companies needing short-term financing will only get it through newly-securitized credit facilities from banks.  Some companies in all of this will die on the vine, deemed not worthy of the risk of trying to save until such a time when the sector’s fortunes change for the better.  And that could be a while.

            Worse yet, some of the most bearish prognosticators on the sector are even warning that---with it so obvious (to them, at least) that a sector-wide recovery is a few years away--the bankruptcies and layoffs still to come could single-handedly doom any hopes of an economic recovery.  Maybe, some warn, the federal government will even have to step in at some point; though how Washington would paper over the problem or bail out the industry is anybody’s guess.

            IS THERE ANY LIGHT AT THE END OF THE TUNNEL?

            The short answer--for now--is NO.

            Earnings and accounting issues will keep capital relatively scarce; and even retail investors sufficiently wary.  Capital spending will continue to go down for some time.  A number of smaller companies and several with the largest debt positions will bite the dust over the next couple years.

            Some think it might be time to bottom-fish.  The question is, where do you start? 

            The Baby Bells (less Qwest) still appear relatively “safe.”   However, what is their future?  As I mentioned earlier, their core businesses have peaked.   Competition is fierce; and margins will get even tighter.  Ironically, once some spark does come back to the sector overall, according to Mark Herskovitz at Dreyfus, the results might actually not favor companies such as Verizon, SBC and BLS.  (Herskovitz is that firm’s senior sector manager for telecom-related investments.)  “The Bells only looked good because the telecom landscape around them was so devastated,” he was recently quoted as saying.  “But when the larger telecom sector begins to come back, the Bells will look stodgy again, and their stocks will wilt.”  As a similar analyst opined on the same vein recently, the Bells could soon end up being regarded as “sleepy utilities” with paltry growth, albeit a fair dividend--but with little room for price appreciation.

            Without a doubt, wireless devices are here to stay.  However, we have two problems in trying to determine whether to catch any of these “falling knives”; which one(s) do we grab for?  I have been following AT&T Wireless (NYSE-AWE) in particular quite closely, and have on a couple occasions come this close to saying, “What the heck...it can’t get worse...this one will survive” and recommending you buy some.  Each time I didn’t make that call I breathed a sigh of relief, as the shares sank anew.  To be sure, AWE has embarked on a very nifty arrangement with Canadian-based Research in Motion (NASDAQ-RIMM) and Sun Microsystems (NASDAQ-SUNW.)  But, at least for now, the environment for tech stocks in general is still so tenuous, that I’d rather wait a while longer.

            The other question gets back to the concept of “creative destruction.”  Even as scores of companies struggle to survive, new technologies are being born that will make communicating even faster and better in the future.  Do we dare buy into what appear to be “cheap” companies now when some are becoming obsolete as we speak?

            Equipment stocks will be the last to recover; only after the direct service providers start feeling a bit better after at least a few quarters’ worth of rebounding revenues and profits will they dare to bolster their capital budgets again.  Whether even such a once-mighty company as Cisco will still have its doors open (let alone legions of lesser concerns) when that time comes is an open question.

            Some investors disagree; and think that companies like Cisco are ripe for the plucking.  This opinion is not without some foundation; after all, during periods of such weakness, it’s customary for the strong to gobble up the weak (provided, of course, that the weak party in question has attractive enough assets and prospects.)   And, I have little doubt that, as the next few years roll along, a few decent companies that have fallen on hard times will be “saved” by a suitor.  The trouble is, those possessing the kind of war chests and financing able to do this are enjoying a buyer’s market; and one that will become more so.  If you’re one who thinks it’s time to buy “good companies” because they’re now “cheap” and will no doubt bring a fat premium in a takeover, don’t hold your breath. 

            Yes, a time will come when the most risk-tolerant investors can begin again to tiptoe into the telecoms.  In my opinion, though, we’re still far from that time.  I have to throw in with Nortel Networks’ C.E.O. John Roth, who darkly warned in a recent interview that his sector is “facing 12 more years of drought.” (My emphasis--and, yes, he said YEARS.)

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