Eli M. Noam
Columbia University
May 5, 2002
Second DraftJuly 15, 2002
The “new” telecommunications industry is
characterized by new technology, new applications, and maybe new market
structures. It is also beset by a new set of instabilities and uncertainties
that will become the theme of telecommunications debates in the next years, in
the same way that the topic of competition had dominated the discussions of the
1990s. If the change is not merely a short-term correction but more
fundamental in nature, managerial and policy assumptions need to be reviewed
fundamentally, too.
Quite likely, the present downturn is only temporary, though no at the hyper level of the bubble years. The real problem for the industry, however, is not a one-time recovery from a one-time boom and bust. The main problem is that the telecom industry is entering a chronic pattern of volatility, with boom-bust patterns becoming a common occurrence rather than an aberration.
Yet manye. pParticipants
and observers of the industry deny the emergence of chronic
cyclicality. But if we if we analyze
the drivers of the recent volatility,
we mustthe sources of expansion and the forces of decline,
conclude that they will be with us into the
foreseeable future, and cyclicality with them, just as they are in
some other industries. Unless, that is, we permit steps that are at variance
with telecom strategy and policy of two decades: the emergence of oligopoly as
a business strategy, and its toleration by government.This is neither
likely nor necessary for the arguments that follow. A
regular cycle would be predictable, and one could therefore deal with it much
better.
Telecom used to be much less volatile than the economy as a
whole. It grew steadily, with long planning horizons hardly ruffled by the
business cycle. But today, in sharp contrast, it the
telecom sector may well have become more volatile than the
economy, more like the construction business, less than water utilities.
The telecom industry was unprepared for such a transition.
Telephone lines had never declined in number before. The financial community
was similarly lost, and its investment advice and valuations, assuming
only growth were wide off
the mark. Being caught by surprise, aGiven this novelty, a
massive hand-wringing and finger-pointing ensued.
Around the world, the same story can be told. Deutsche Telekom’s debt in 2002 is $64 billion, France Télécom’s $68 billion, Qwest’s $25 billion, and Telefonica $20 billion. As a percentage of annual revenues, France Télécom’s debt is 141%, Deutsche Telekom’s 140%, Telefonica’s 92%, BT’s 75%, and Telecom Italia’s 67%. The cumulative debt of the seven largest European telecom firms is greater than the GDP of Belgium.
This question is important, because if we do not know why
something happened, we cannot predict,
prevent, or encourage recurrence. [1] when
and how it will go away or re-appear.
There are many competing explanations for economic cyclicality, from sunspots to the alignment of the planets, from interest rates to insufficient demand or random shocks. For telecommunications, some explanations are interest rates, otheres insufficient demand. But, one cannot really blame a drop in consumer demand on the downturn. True, the growth rate in the internet subscribership are not as torrid as before – it was “only” 30-40% in 2001. Similarly, the usage of long-distance minutes, data communications, and wireless minutes keeps rising.
Perhaps the most obvious causes are two: overcapacity and the
re-emergence of economies of scale of through
network technologies such as fiber and wireless. The
fixed costs of networks are high and the marginal cost are low and dropping –
the classic attributes of “natural” monopoly. Scale effects are
compounded by “indivisibilities” or “lumpiness” in investment, which leads to
short-term excess capacity. Hence, the advantage of being large
are greater than before. Size matters. For mobile wireless
telecom providers, greater size means lower cost and higher profits.
Competition drives prices down to marginal costs, which are way too low to
cover the large fixed costs. Firms lose money and go out of business.
[Rob: where is the 2nd
graph from Booz Allen repost? I faxed it.]
The second factor is overcapacity. Assume The network companies
over-optimistically projected long distance market shares. Everybody built
capacity to overwhelm competitors and gain size. Capital expenditures
grew by an annual rate of 29% from 1996-2001. It was further
assisted by the tendency of stock analysts to value a firm’s progress by
physical measures of its infrastructure, such as cell-sites and fiber-miles.
As the result of these factors, some carriers had over 90% of their fiber
“dark” and prices dropped dramatically. The ___________ of
bandwidth fell by about 54% annually.
For trans-Pacific transmission, the prices of high-capacity circuits dropped by 87% in two years.
Technological and economic obsolescence will gradually take
capacity out of circulation. Satellites, for example,
eventually leave burn up. do not stay up
forever, for example. But disinvestments takes time. For Texas office space, it took over a decade in the 1980s,
to dissipate the excess supply. For 19th century railroads, it took
many decades. Thus, the capacity overhang in telecom will remain
for a long time if it is reduced merely
by obsolescence. The key for a recovery is a substantial growth
in demand, probably from mass-media uses of the internet such as video. But
this will take time.
In the meantime, what will telecom firms do?
One obvious response is to cut cost. A second response is to become more innovative. These strategies will be matched by competitors. The problem is that with incremental costs so low, competitive prices will not cover the considerable fixed costs.
Similarly, [ADD]for its
capital structure, firms may substitute corporate debt with convertible debt or
preferred equity because this enables
them to reduce a debt load in a downturnDeclare
Bankruptcy. This step (e.g., a Chapter 11 reorganization) may
wipe out debt, but will also make investors and lenders wary of future
participation with the firm or its industry.
Engage in price cutting. But these price cuts are matched by competitors, which gets to the main strategy: Raise prices, by establishing collaborative cartels or oligopolies. Hence, there are incentives to oligopolistic cooperation entailing the mutual reduction of capacity rather than engaging in price wars.
§Diversify in product
markets and geography. This reduces risk in some ways, but also may get
a firm to move outside its core area of competence, which increases risk again.
Expansion into other countries poses a problem of timing and exposure to
political vagaries. Expansion into related elements of the value-chain create
synergies but may tie one part of the firm to others within the same corporate
family, even if they are costlier and less desirable. It can also lead to a
competition with one’s own customers. And, any expansion into multiple product
lines inevitably creates and requires changes in the firm’s corporate culture.
§
§For a firm’s stability,
in a volatile environment, stock is better than debt. Since it does not
require interest payment in a downturn situation. The increasingly high debt
load of telecom firms used to finance various ventures thus subject these firms
to more stress. Now the real prospect of default sends shudders
through the financial community and leads it to support incumbents’ and their
profitability against new-style entrants.
When the industry becomes volatile, many investors leave. Market power, on the other hand, lowers risk, and raises prices and cash flows. One can see how market power benefits market valuations. In America, rural LECs, facing little prospect of competition, maintained their value much better than other telecom firms. In other countries, Telmex did better than most large incumbents, mostly because of its hold over the Mexican market. Its stock rose 28% in the first four months of 2002.
OBut over-expansion,
by itself, is a hallmark of health, not weakness. At one time or
another, tEarly railroads were vastly overbuilt in the US. here
were hundreds of companies running railroads, making automobiles, flying
airplanes, and assembling microcomputers. One of the functions of a slowdown
is to permit consolidation. That is, to reduce competition, t. To
reduce the commodification that lowers profitability and future investments.
This must be a telecom firm’s overriding strategy. The present contraction will
therefore inevitably raise industry concentration, slow innovation, reduce
capacity expansion, and raise prices. (This strategy will, of course, be
publicly denied by the survivors). Regrettably but
realistically, wWhat
will turn the telecom industry around will not be more competition but more of
an oligopolisticy market
structure, coupled with increasing demand.
We have analyzed the strategic options of telecom
firms and of their investors, and concluded that the most likely scenario is
one of consolidation. Once recovery is on its way, additional competitive entry
is likely again. In time, such competition will generate overcapacity,
plummeting prices, and the cycle will turn downwards again, with marginal firms
failing.
For public policy, this suggests, as oneseveral
alternatives. The first alternative is
to let nature take its course through the business cycle, relying on natural
contractions and expansion cycles. This approach recognizes
realistically the difficulty in identifying problems and creating
timely and workable solutions to them. However, this policy
is less likely to be chosen by politically sensitive regulators when the
downturn persists, when essential service providers falter, and when service
quality deteriorates, and employment drops.
The second option is for government to take an activist, almost macro-economic, approach to the sector and try to raise it from recession. This would involve significant and ongoing intervention. A related but less intrusive strategy would be to automatically adjust existing rules and requirements over the business cycle.
The third option is not to focus on the downturn itself but on the responses by the telecom industry to it.
The main tool for government is to modify its Competition Policy. Perhaps most important is the government’s policy in permitting or preventing market power. The challenge is therefore to deal with an environment of potential oligopoly. On the one hand, oligopolies help generate greater profitability and lower volatility. The downside, of course, is that the users pay for this greater profitability in higher prices, potentially lower service quality, and slower innovation. Several of these problems might be dealt with onside of the market structure, by regulation such as price caps or minimum service level requirements, triggered by high levels of market concentration.
This would mean, a benign neglect of oligopoly in the
downturn. It would mean that the vigor of pro-competition policies itself
should be cyclical, and take into account the macro state of the industry. This
would require a fairly radical departure from the regulatory philosophy of the
past 20 years. For a generation now, liberalization, deregulation, and
competition have been the keystones of telecom policy and strategy. Now, one
business cycle later, and facing future volatility, we may have to get used
to the idea of living with oligopoly in
telecom rather than the hoped-for
competition.The second alternative
is to let nature take its course through the business cycle, relying on natural
contractions and expansion cycles. That policy
is less likely to be chosen by politically sensitive regulators when the
downturn persists, when essential service providers falter, and when
service quality deteriorates. A
hands-off policy assures that government’s regulatory process does not add the
kind of lags that create or accentuate oscillations in response. .
[Insert W]
Telecom stock prices,
using February 1996 as the benchmark of 100, rose from about 70 in January 1995
to 225 in March 2000, and then fell back to about 80 in March, 2002 (Standard
and Poor’s in Alleman, 2002). Of
28 publicly traded competitive local
exchange companies, 13 went bankrupt in 2001. [add earnings, investments and
reven
[1]
It is necessary to differentiate telecom
from the internet sector. This The The
internet sectorlatter, though interrelated, operates
under its own dynamics. Most internet projects were uncertain and unproven due
to their novelty, and one should expect exuberance and failures. In contrast, ,in
telecommunications the basic business is was well
established and stable. The internet’s inherent riskiness
was clearer understood than that of the telecom sector.