The end of the year finds investors in the competitive local network carrier sector wondering how long a road it will be back to the future, when stocks will again be on the rise and confidence in CLECs' ability to take a rising share of the $100 billion market for local telecom services will be vindicated. Simply put, soaring demand for lines and services has not been enough to protect the sector from the squeeze imposed, on one hand, by falling prices induced by rising competition and, on the other, by a failure to get past the 5 percent market penetration mark.
 |
| David Helfrich principal, ComVentures |
In the ensuing discussion, conducted Oct. 13 at Lucent Technologies Inc.'s (www.lucent.com) Financial Summit in San Francisco, leading investment and service provider executives take the full measure of the competitive carrier sector from the investor's and entrepreneur's points of view. As the conversation attests, the good news is that there remains plenty of confidence that the road ultimately will be worth traveling. But what are the new keys to getting there? Will consolidation be the only trend line worth pursuing? Is the hope vested in enhanced service revenues pie-in-the-sky against a backdrop of failed execution in such fundamental areas as timely provisioning of services, customer care and OSS integration? Are technology issues surrounding DSL and other access platforms, packet telephony and standardization of key applications interfaces close enough to resolution to merit confidence that 2001 will begin to deliver on the promises? How these questions are answered in the marketplace in the year ahead will determine just how long the return to more solid ground will take.
In this edited transcript of the Financial Summit's investment roundtable, which has been edited from the recorded transcript, participants offer a start on assessing how these and other issues might play out in 2001 and beyond. They include: Larry McLernon, executive vice president at CLEC Dynegy Inc. (www.dynegy.com); Greg Rossman, a partner at Pequot Capital Management Inc. (www.pequotcap.com), a firm that focuses on early stage venture and private equity and hardware and communications equipment companies; Ted "Dub" Snider, CEO of broadband ICP Connect.com (www.connect.com); David Helfrich, who as a principal in ComVentures (www.comventures.com) focuses on starting businesses in new markets for WAN and remote access products; Doug Grissom, a director at investment management firm Madison Dearborn Partners (www.mdcp.com), and Fred Dawson, vice president of editorial operations at Virgo Publishing (www.vpico.com), publisher of xchange. The moderator is Michael Katz, former chief economist for the FCC (www.fcc.gov) and current director of the Haas School of Business Center for Telecommunications and Digital Convergence (http://groups.haas.berkeley.edu:80/fcsuit/ctdc.html) at the University of California, Berkeley.
Katz: Are we only going to see a handful of carriers or is there going to be room for smaller carriers to survive and prosper?
Rossman: We believe that consolidation is going to play a key role in the formation and the development of the CLEC world. There clearly are a number of potential consolidation activities and opportunities out there in between companies, and I believe over the next 24 months we're going to see an investment banking heyday as people consolidate and work to build stable platforms that can justify the financing required to build out the networks.
McLernon: The local-loop aspect of the communications industry is probably five times bigger than the long-distance industry, so to get footprint quickly, it's very unlikely that it will just be controlled by major players. In the past, this industry has always seen the same cities attacked with gusto for market share, and in order to get full dispersement out into the rural areas, you're going to need the small player. And the small player will always be a part of it. So at the edge of all this technology, it's usually the small player that takes the risk and establishes the market. And I think that will continue. I also believe consolidation is a good piece of it.
Helfrich: One of the things happening now, though, that has us a bit concerned is that, usually, when you have consolidation, you like to see it come from a position of strength. And what we're seeing right now is a lot of consolidation from the position of weakness. I think that's unfortunate. Part of the problem out there in the marketplace is due to people like myself and some of the other panelists who have very aggressively put capital into the markets, funding maybe too many companies and then quickly turning off the spigot.
You know it's bad enough that we turned it on as hard and as fast as we did, but then we turned it off, and there's plenty of blame to be spread to everyone. The venture community, I think, largely put the money out there because it was available to them and the public capital markets were as strong as they were. But we're going through--especially at the very low end of the broadband access market--a very painful period that I think defies economic reality in a number of ways. And I think it's going to be corrected. But as far as consolidation is concerned, I think the thing that has us the most worried is that it's coming from a position of weakness in the market as opposed to a position of strength.
Snider: The consolidation we've seen so far is really the tip of the iceberg. It's really the smaller iceberg before the iceberg behind it. The real consolidation is going to come when we begin to see companies with strong management teams and the right business models emerge. And there are economies of scale that are going to drive that, and we certainly hope that's going to happen. And, personally, I'd like to see Connect.com be the consolidator.
Dawson: One of the ways around the whole issue of consolidation and how these people survive and also how they address commoditization is service reach and fluidity, which has to do with the clusters of alliances that are forming around certain next-generation long-haul carriers and local allies who are trying to offer customers access across the whole footprint, with the provisioning, with the SLAs, with all of that pretty well fixed. And I think that's how it's going to go for a while.
 |
| Doug Grissom, director, Madison Dearborn Partners |
Grissom: That starts with one service doing that well, like the DSL providers did, but over time it's transitioning that to other services like voice and video and cable, and being able to really hold on to that customer and over time offer them more and more applications that ride on that network, even at the local level.
Katz: Let me tie together two things that Fred just said. To what extent--and we're talking now over the next 10 years--before we're getting to bits being transported as a commodity, are carriers going to have to rely on end-to-end service provisioning? To have guaranteed quality of service; have low latency steps in real time; to offer security? Is that going to be a way for carriers to differentiate themselves, differentiate what they're offering? Is that something that's going to drive either alliances or consolidation?
Helfrich: Security is a big issue from an investment standpoint. We love security because I think it's one of the things that people won't forfeit during tough times. And right now times are a lot tougher than a year ago.
McLernon: I have come to the conclusion that we really have fallen in love with technology as an industry, both the financing side of it and the operating side of it. And that a company's success, including the evaluation of their management, is really a result of how well they did in an IPO. So now the bloom has come off that rose somewhat, but it's still there. I find, in dealing with different people in different organizations, when you ask them who's the customer, you get kind of a blank look back at you. And if you look at the CLECs themselves, did the CLECs ever really find out, did they ever settle who their customer was? Were they ever successful at it? Five years ago, the number was 5 percent [share] of the market; today it's still 5 percent of the market.
And I make another distinction, which is that we have products and applications, and products are the legacy part of this industry, and applications are the new part of this industry. Products, in my opinion, will have the tendency to be bundled together and offered with a flat price, and applications will have special delivery associated with them, which will distinguish not only the person providing them but the person delivering them if they have a proprietary interest in that.
But above all ... something that I think we forget many times, and has severely influenced the CATV industry: If you can't bill it, it's a hobby. So you have to be able to bill these different services; otherwise you're not going to go anywhere, including video, including streaming video. The brittleness of the whole revenue structure and margin structure associated with that is inhibited by the fact that there aren't comprehensive billing systems to look at bits and report time of day and maybe quality of service. So I think billing is certainly as important as security. I know that I don't have to have everything that I transport secure, but I know I better be able to bill everything I transport.
Snider: I agree with Larry completely. It seems to me that security has really something that's got to be as far out to the edge of the network as possible, or you have a vulnerable point in there. Next-generation carriers have to be service delivery systems. The transport and the security is just one piece of that, but the company has to be conceived from the ground up to integrate the billing and the OSS and the network and the marketing strategy to be able to deliver the value-added services. So it's not, anymore, about a network plant with some management layered on top. It's got to be a truly integrated platform.
Katz: What are the biggest unmet customer needs? Where do you see carriers and service providers generically falling short, and that there really are opportunities to do better?
Rossman: Differentiation and the message. If I make ball bearings, and I'm the best ball bearing manufacturer on the planet, or one of the best, how is it that your service suite that you provide differentiates you from someone else? And why should I choose you as a carrier over another carrier? I go out and talk to the network planners to help my hardware practice, but in those conversations I try to talk to some end users and to some CIOs, and some of the feedback today is that it's hard to remember what the carriers do. And why one is better than another, and differentiating.
Helfrich: There are a couple things happening here. It's going to be less important to differentiate than to provide service. And maybe I'm a little bit tainted because I'm working already in markets where the technology and the differentiation have been pitched for the last three years. The big problem is that people are just getting terrible service. And in particular--you look at cable and you look at DSL--if anyone could deliver a reasonable service, at all reasonable, I mean, install it within two weeks, three weeks, give a call-back within a day, two days, even install it within 3 months--and communicate! It's really, really pathetic!
Grissom: That's exactly right, especially in two market sections: the residential market and the small to medium-sized business segment. The large business--that's the sweet stuff; everybody wants those customers, the ILECs in particular. But if you go out and talk to the small to medium [-sized] businesses, they haven't heard from their ILEC in two years. They don't know who their representative is--no one calls on them. We still think there are huge opportunities to provide the type of service that you're describing.
Snider: That customer relationship is going to be the key differentiator we're going for, because we're not just providing connectivity anymore, we're providing functionality. And for customers to be willing to trust their carrier, to buy their accounting application and have it hosted off site, they've got to know that person, and there's got to be a level of trust there. So that customer focus and that customer relationship is the key differentiator going forward. It's not technology.
Katz: Let me ask this: Is customer focus or high-level customer care something you can sell to capital markets? Or does it have to be, "So now we've got the new service, the new technology"?
Helfrich: Yeah, it's a tough sell. So for us, anyway, I think that it has to be because it's an intangible. It's kind of like the many network-management/no-assets companies that come to us. We understand the need for it and the importance, and in fact have invested in companies, but there haven't been a whole lot of winners. This is a fuzzy kind of an area. It's a people ... it's almost a cultural kind of a thing, and it's hard to fund.
Snider: Here's where the technology comes into play. The new-generation technology gives us a lower cost structure. And so what we have to do is use that to save money on our network side so that we can invest in the customer side, because it costs money to deliver a quality customer experience. And so that's the advantage, I think, for next- generation carriers--[to] take your lower cost structure, re-invest some of that into customer service--your whole service delivery system--and still end up with a good margin.
Grissom: That's exactly right, and it's not only the network savings. It's also selling the bundled package so that you have the revenue coming in the door so that you can justify making a call once a quarter to the customers and asking them, "How do you like your service? How are things going? Is there anything we could be doing better?" And I think those are the things that are going to set the winners in the service provider market apart.
Dawson: I don't think this is an "either-or" situation. Really good customer service and quick provisioning are part of the differentiating thing. And certainly network-based security can be another differentiator. There is that first-to-market factor with the things that eventually everybody will do that gives a specific carrier an advantage. But there's another one that's coming along that has held this market back in terms of expectations for this time frame, which is multiple-line packet voice service over DSL. That was supposed to be ready to deploy by now, and, largely, it's not. People are still having problems with scaling, so it's getting pushed into next year. But I think that's going to go a long way toward alleviating some of the investment pressures that we're seeing right now, because that's a true differentiator.
Helfrich: I agree, and I'm extremely disappointed. The one thing about the voice over DSL is that it's a beautiful economic model. It is such a strong pure economic play that it's a bit surprising that it hasn't taken off more quickly. And we're investors in TollBridge (Technologies Inc., www.tollbridgetech.com), the leading voice over DSL company, who's got a partnership with Mpower (Communications Corp., www.mpowercom.com), who is, in fact, offering a great bundled service. What we're finding is that these newer carriers are still having operational issues that are challenging them and that are preventing them from rolling it out and scaling as quickly as they'd like to. If you look at this thing from afar, you say, "Gosh, all the pieces are there, the technology is there, we've got the money to do it," and so you say it's going to go just like that. And then you get people involved, and all of a sudden everything shifts at least by a year, and maybe it's worse than that.
Rossman: The last five comments have all been about one central theme, and that's timing. It's taking longer. Use that for a moment and put yourself in the position of an analyst on Wall Street. What to do with the stock? It's going to take longer so no longer do I view the IPO as this momentous event. The IPO is nothing more than another round of funding. And it's going to take a lot longer to build out your network because it does take longer, fundamentally. How do you operate in this environment?
Dawson: Yeah, we have a new answer to the chicken and egg question, "Which came first?" It's Chicken Little.
Katz: What is it that capital markets are doing wrong today? Are there ways in which they're distorting the outcomes? I mean, it's an unprecedented time for the availability of capital for entrepreneurship, but clearly, not all is perfect. So do any of you panelists have a thought on what's wrong?
Helfrich: I think, very fundamentally, that what the capital markets--at least, the private capital markets--have rewarded was subscriber growth, at the cost of solid fundamental, economic business models. And I think that, in a nutshell, is the sin that's been committed, that we're now having to undo.
Snider: It's a great time for contrary investors because we all identified this mountain of gold, a $200 billion-plus market, and that new entrants are going to garner 40 percent of that, $80 billion. And we rushed in, and all the elements weren't quite there yet. Maybe we had people that were lacking the management experience or telecom experience. You had people who were deploying immature technology; you had some faulty business models. And it's really only now that all the ingredients you need are there. You know, three years ago, there weren't people who had experience with this. It hadn't been done before. Now there are some people out there with scar tissue. The technology has matured tremendously over the last couple of years, and the support systems to make it all work and deliver a quality customer experience have gotten much, much better and much lower in cost.
McLernon: The CLEC market is kind of a tragedy, and I think it was brought about by a number of different things. One, people actually started CLECs because they felt in two years they'd be bought out or they'd be consolidated. They ignored the customer and they concentrated on building their network. There are networks today that are built and not connected--large networks that are built and not connected. The second thing was that we went through this whole hysterical moment of the IPO. And during that period there were companies--and some of you guys have invested in those companies--who were planning their business based upon their last visit with the analysts. Not on the customer, not on the service, but on what the analysts told them.
So if the analyst said, "It's gonna be DSL; DSL is a big play," they rushed back and said, "We gotta invest in DSL." And at that time, there was plenty of money to go around, so we got this whole false aspect to the industry. And then people were getting rewarded based upon the value that they got for their shareholders; based on a false market rather than their capability to manage what they had to a successful conclusion, if they couldn't sell it or consolidate it. That was a huge mistake. That has changed, but we're dealing with the detritus of those changes.
Playing Through the Pain
Don't Look for Exit, Watch for Better Execution
By Fred Dawson
Anyone looking for reasons to be skeptical about the investment and growth potential in the competitive local communications services marketplace doesn't have far to look as 2000 comes to a close. Big headlines cast negative shadows on telecom in general with news of the AT&T Corp. (www.att.com) and WorldCom Inc. (www.wcom.com) breakups, and evidence and rumors of problems within the ranks of local service providers tend to reaffirm the general impression that something is wrong.
But, among the investors and operators in the game, this is more a time to be looking for opportunities than to be considering exit strategies. If, as Jonathan Nelson, president of Providence Equity Partners Inc. (www.provequity.com) puts it, "the rising tide lifted all boats, including leaky boats" in the "incredibly bullish market" that ended in midyear, the falling tide that marked the second half has created a chance for investors in private and public markets alike to get good buys on the boats that are proving to be seaworthy in harder times.
"There are companies that don't deserve to be as big as they are, and many who don't deserve to be as low as they are," Nelson said during a panel discussion at the recent Bear, Stearns & Co. Inc. (www.bearstearns.com) Global Communications Conference in New York. "This presents opportunities. The drivers are in place to propel very attractive areas to invest in."
Indeed, Robert Nicholson, managing general partner for Spectrum Equity Investors (www.spectrumequity.com) in Boston, sounded what appeared to be the consensus note at the Bear Stearns conference when he said, "This is a very favorable time for buyers like us." As he and other venture capitalists noted, not only has the IPO route to funding lost its luster, the drying up of the high-yield debt market has made private equity investors the main capital recourse for emerging telecommunications firms.
But there is no consensus on what the current state of affairs means for the evolution of the competitive carrier sector in the near term. Bear Stearns analyst James Henry recently predicted that the number of players, now at about 45, could well be halved through consolidation in the year ahead, but, among the ICP executives addressing the question at the conference, only one, Royce Holland, chairman and CEO of Allegiance Telecom Inc. (www.allegiancetelecom.com) agreed with Henry. "I'd say there will be 20 to 25 [acquisitions]," Holland said. Estimates from three other executives sitting on a CLEC panel with Holland as to how many such deals there would be within the sector over the next 12 months ranged between three and 12.
But there was agreement that there would be at least some increase in the pace of consolidation, which produced three such deals in 2000, if Time Warner Telecom Inc.'s (www.twtelecom.com) acquisition of the assets of the bankrupt GST Telecommunications Inc. (www.gstcorp.com) is included in the count. "We see two types of acquisition opportunities," noted Steve Dubnik, chairman, president and CEO of Choice One Communications Inc. (www.choiceonecom.com). "One, which is more a short-term situation, involves companies who are not meeting their goals, and the other is longer term--where we would find companies like ourselves who are succeeding and who are a strategic fit."
 |
| Richard Ellenberger, president and CEO, Broadwing Inc. |
But it's the importance of finding a strategic fit in the context of there being so many different business plans, technology platforms and approaches to OSS in play that prevents the successful companies from quickly consolidating with each other on a grander scale, noted Rolla Huff, president and CEO of Mpower Communications Corp. (www.mpowercom.com). "The fact that people saw a better valuation opportunity by going out and getting their own funding rather than selling out has been a big factor in the pace of consolidation, but differences in business plans have held things up a bit as well," he said.
Getting bigger for the sake of getting bigger when the different pieces don't scale together into a more attractive service offering is not necessarily the smart way to go, Dubnik added. "It has to be a fit," he said. "The desire to grow in size might not be the best acquisition strategy when the opportunity to grow in scale is much greater."
Further diminishing the pace of consolidation at this point is wariness over the potential for more problems within the sector, noted David Solomon, chairman and CEO of Gabriel Communications Inc. (www.gabrielcom.net). "There's a wait-and-see attitude relative to new deals," he said. "There's a concern that there will be one or more bankruptcies in the next six to 10 months and what the reaction to that will be in the marketplace."
Nonetheless, Solomon added, more consolidation is inevitable. "This is a business of size and scope," he said.
Clearly, as two other executives stressed, the overarching concern in the year ahead has much more to do with execution on existing assets than it does with any efficiencies to be gained through consolidation. "Every once in awhile you have to run the company," said Joseph Nacchio, chairman and CEO of Qwest Communications International Inc. (www.qwest.com), which absorbed US WEST at a furious clip this year, and is now moving to capitalize on the synergies. "I'm in no hurry to be an acquirer."
Richard Ellenberger, president and CEO of Broadwing Inc. (www.broadwing.com), sounded the telecommunications industry's theme for 2001 at another recent industry event. Addressing the CompTel Conference in San Francisco, Ellenberger said, "Customers and investors alike are looking to the next 12 months as a 'make or break' period during which success will be determined by a provider's execution against old business plans to leverage technology advances that enable customers to gain disruptive advantages in their markets."
This is especially true in light of all the money that has been spent on advertising a future that hasn't arrived, Ellenberger added. "I believe that in the heady atmosphere of dot-com mania and almost daily technology breakthroughs, no one has yet created the complex infrastructure and sophisticated environment to nurture these promising applications into tangible business drivers for our customers," he said. "Customers are feeling that they have a better chance of finding a gold nugget in their backyard than they do of actually having a 'killer app' that lives up to its promise."
That must change quickly, and it should, given the fact that companies like Qwest and Broadwing are spending hundreds of millions of dollars on putting the infrastructures in place that will make those much-hyped killer apps feasible. "In some ways this [current market downturn] is a great opportunity for companies that can execute," observed James Perry Jr., managing director at Madison Dearborn Partners (www.mdcp.com), who was another speaker at the Bear Stearns conference. "The situation will focus the capital markets' attention on the good companies, isolate the good from the bad. We're back to where we're building companies that can prove themselves."
