Can a Down Economy Offer Telcos an Upside?

In my previous blog, I wrote about VoIP and Internet security threats. I had planned on continuing that thread in this installment but, considering the state of the economy and its prominence in the news, in this blog I’ve decided to focus on the challenges and opportunities arising during these difficult times. I’ll get back to VoIP security threats in a future installment.

The current financial crisis has seeped into the telco world and is affecting it in several ways. Strained confidence of customers, employees and employers alike is an obvious result. Given current conditions, many projects are being cancelled, delayed or downsized. The impact of this has already been seen with several telcos announcing restructuring plans including lay-offs to reduce over-capacity of labor and the trimming down of capital purchases.

Another challenge being seen currently is one of liquidity. The Telco 2.0 folks have a good thread on this. The credit crunch and the rise in borrowing costs, especially for several large telcos with debt maturing in the 2009-2010 timeframe, will create refinancing risk pressure. Six telcos (Vodafone, DT, FT, Telefonica, BT and Telecom Italia) have around $37 billion euro maturing in 2009 – 2010. Every 100 basis points increase in debt translates to $375 million euro in interest. This may impact cash generation and hence capex spending in order to maintain dividends. Another challenge is in the area of capital markets. Obviously, both venture and private equity financing will be increasingly difficult to come by. The time horizon for IPOs has faded beyond recognition, leading investors to consider other exit strategies with a bias toward selling the asset to established players.

Yet, these same challenges also create opportunities for telcos. The implosion being created by businesses hunkering down and behemoths such as Nortel collapsing — along with the uncertainty the economy creates for employees — has made it much easier for companies to hire top talent. Additionally, assets from VC’s and private equity firms can be monetized by telcos either fully as wholly owned assets or partially via strategic engagements. This funding can be used to develop areas telcos are not willing to tackle on their own right now. This is also a time when institutional investor money is rotating into the telco sector as a defensive mechanism in response to the beating being taken by the other industries.

The fact is, at a time when investor concerns are focused on “leverage,” telcos look relatively conservative. Analyst consensus forecasts show leverage (defined as the ratio of net debt-to-EBITDA) at well below 2.0x for the vast majority of major telcos over the next two years. In some cases (such as China Mobile) companies are sitting on significant net cash positions. In contrast, alternate carriers with private equity-backing such as cable companies carry 4.0x to 7.0x in leverage.

In the consumer and enterprise space the focus has moved to more bandwidth intensive applications and fixed mobile bundles, marked by stabilizing prices. Telcos with both fixed and mobile operations have the scale and geographic reach to deliver these services, particularly when compared to alternate carriers such as cable operators who do not have wide presence, operational scale and are heavily leveraged. This need to cater to high-bandwidth services with the telcos’ assets mentioned above will likely prompt regulators to offer telcos incentives to build out their networks in the longer-term, which in turn could drive up stock prices.

Telcos with the conservative 2.0 x of leverage should consider teaming up with over-the-top players (OTT) such as Google, Amazon, Microsoft, Cisco, Apple, Ebay etc. These companies have negative leverage (net debt / EBITDA) given their strong cash positions, zero debt and innovation potential to unleash new business models and drive growth. There is an opportunity for telcos who are not distracted with the current crisis to partner with these OTT players and transform themselves to create value using their latent assets.

It appears based on this analysis that incumbent telcos, especially those with both fixed and mobile assets, are in a very strong position compared with their private equity backed brethren. So while there is no denying that the economy is down, there is an up side that can present savvy telco operators with opportunities.

Also, what does this mean for telco vendors? Outside of cash laden IP vendors such as Cisco, traditional telco vendors such as Nortel, Lucent, and Ericsson will experience a consolidation in their sector. Pricing pressure along heavy customer support and massive Next Generation mobile network deployments from the Chinese networks using Chinese vendors will ensure the rise of the Asian telco vendors such as Huawei and ZTE.

The implications of these economic trends on Next Generation architectures will be slow but focused, with adoption of IP based technologies enabling lower capital spend, increased operating efficiency and potential for higher revenue growth via newer services.

Ajay Joseph is CTO of iBasis, responsible for the technical strategy, innovation and engineering of the company’s global telecommunications network and supporting systems. Prior to joining iBasis in 1999, he worked in engineering and design for companies including GTE Internetworking, DeskNet Systems and NYNEX Science & Technology.