Stunted Growth
A team of tech-telecom specialists sees more static ahead for investors
An Interview With Scott Cleland and William Whyman ~ As principals of the Precursor Group, an independent research boutique in Washington, Cleland and Whyman supply institutions with investment intelligence on telecommunications and technology, based on a thorough reconnaissance of the field and supplemented by their strong industry and government connections. The two have distinguished themselves through an ability to alert clients early to trends of consequence. Not only are they plugged in, they are impartial. That's the critical difference separating them from the rest of the pack. And it's a quality that allows them to focus on producing penetrating analysis for the hedge funds and top money managers who pay up for the privilege. For their current outlook on the state of telecommunications, read on.
-- Sandra Ward
Barron's: You seem to have changed your views on the telecom sector.
Cleland: We are concerned that "Enronitis" has hit the whole sector and no one is safe from the debt-spiral dynamic going on in telecom. It's a very negative overall dynamic.
Q: Is your concern about access to the capital markets, or something more?
Cleland: It's a lot more than that. There are severe fundamental negative trends occurring in telecom. First, there is too much debt. It will have to be worked off. There is huge overcapacity in the system and no one can afford to take on more debt in order to cull the overcapacity.
Q: This was true a year ago. What's changed?
Cleland: What has changed is that no telecom company right now is strong enough to be the cavalry to rescue everybody else. We thought the Bells were going to remain strong players that could come in and take out the overcapacity and that would be the rallying point that allowed the sector to stabilize. After Enron, even the biggest companies, the aircraft carriers like SBC Communications, Verizon and BellSouth, the three that could still raise capital if they wanted to, have no desire to take on additional debt or additional business risk. Most people thought consolidation was a dynamic that could stabilize this sector, and now it's every company for itself. We have a situation where no one is willing to pluck somebody out of the water and put him into their lifeboat.
Whyman, left, and Cleland have a cautionary view of tech-telecom now: "The bubble was so extraordinary" that "the past is a horrible guide to the future."
Q: Isn't there a price for everything, especially a strategic move that could help future business?
Cleland: What we've seen over the last year is that even at pennies on the dollar people didn't want the CLECs. The reason they didn't want the CLECs is that they didn't want to take on new liabilities. What is happening here is a very negative dynamic. The companies that have too much debt are going to have to restructure. The existing bondholders are going to be the losers. Coming out of a restructuring, the companies will then need to take share. The only way they can take share is by lowering prices. That creates competition on steroids. What concerns us is that this could be a dynamic where overcapacity continues to exist. It could be like the steel industry, where companies go into bankruptcy, restructure, come back and lower prices, and still find themselves not making it. The overcapacity in the transport area is spectacular.
Whyman: It is not just a question of debt. It is deeper. The economics of bandwidth will, as Scott said, start to look like a commodity product. You have excess capacity, high fixed costs and falling prices. The analogy to the steel industry is a good one. You look at the economics of it, you look at charts and you say to yourself, "I've seen this chart before and I don't like it."
Q: Except the steel industry seems to have had a longer run than some of these companies.
Whyman: Technology changes a lot quicker. I also would argue that the steel industry had a lot of government support in terms of tariffs, which basically end up driving prices up. In the telecom industry you've had the FCC and the Telecom Act driving prices down.
Cleland: The monsterish trend in telecom right now is hugely negative for margins. The industry is shifting from high-margin voice minutes to very low- or no-margin data minutes. There's the huge trend of wireless substitution where people are moving in large numbers from profitable wireline minutes to much lower margin wireless minutes.
Q: Prices continue to drop there, too.
Cleland: Prices don't drop in wireless; more minutes are given away. They're totally commoditizing wireless and it is having a negative effect on wireline as well. Government policy has made this competition dynamic a disaster. The government sucked capital out of telecom in a big way and created enormous disincentives for investment. Then there's the debt spiral we're in now. We're left with less profitable migration to voice, less profitable migration to wireless, a hyper-competitive deflationary government policy of competition and overwhelming debt. Put the four together and the economy can't pull this sector out of its hole.
Q: What can? What has to change?
Cleland: That's what really concerns us. This is a dynamic that will last awhile. This sector is not going to bounce back quickly. We tell people telecom-tech is no longer the economic propeller of the economy. It may be a drag.
Whyman: From 1997 through the third quarter of 2000, investment in equipment and software was adding roughly a point to the gross domestic product growth every year. It was responsible for roughly a quarter of all the growth. Starting in the fourth quarter of 2000 all the way through 2001, it has actually been a drag on economic growth. It has gone from roughly adding a point of GDP growth to knocking nearly a point off GDP growth. That's a big deal.
Q: You speak generally of telecom, but which sector is this most acute for?
Cleland: This dynamic is worst of all for the equipment segment and especially the data optical segment. This segment was the biggest part of the bubble during the late 'Nineties. Those stocks literally levitated the Nasdaq by mind-boggling proportions. What we have right now is what we call "beta parking," where investors have parked in high-beta stocks that were high growth in the past, hoping they will roar back.
Q: Companies such as Cisco and ...
Cleland: Cisco and JDS Uniphase and Ciena and Juniper, and Sycamore Networks. Demand overall is getting crushed.
Whyman: In 2000, investment in communication equipment grew by 25%. In 2001 it fell by 22%. It went from plus 25 to minus 22. It is literally falling off the charts.
Q: So when we get a negative warning or a cautious outlook from one of these companies, it sounds like we're not even hearing half of what's coming.
Cleland: The problem investors are having with telecom-tech is that the past is a horrible guide to the future because the bubble was so extraordinary and the past numbers were so illusionary.
Q: What does the future look like?
Cleland: Much slower growth. A very troubled, cannibalistic competitive environment.
Q: Have you drawn up some sort of pyramid or ranking system of those most likely to fail and those areas that are less risky?
Cleland: Yes. We call this a snorkel environment because most of these models are either underwater or just at the surface. The CLECs are the deepest underwater. The long-distance players are at the surface and need a snorkel. The only companies safely above the surface are ones with reliable consistent positive cash flow and those are the Bells: SBC Communications, Verizon Communications and BellSouth. If there is a relative safe haven in telecom, it's in those with consistent positive cash flow.
Q: Relative safe havens doesn't sound like a ringing endorsement of a place for investors to put money.
Cleland: Every telecom company is interconnected to the whole system and this system is very sick.
Whyman: We've told our clients that, based on our sector analysis of the fundamentals -- the technology, the competition and the regulation -- they should be underweighting telecom. They should be avoiding the CLECs, long-distance, and equipment suppliers.
Q: Around this time last year everybody thought we would see more consolidation than we did. Enron imploded in December. Trends were in place before Enron. Explain that.
Cleland: It wasn't being picked up that ... the CLECs and WorldCom were shopping themselves, but people weren't buying. Companies were waiting for a lower price. After Enron, it became an issue of capital preservation and a safety dynamic. It was no longer reasonable to be opportunistic if it endangered your survival. One core theme I am trying to get across is that telecom is not growing.
Q: What else is at play here?
Cleland: The steep demand curves we saw for wireless, online access and personal computer growth are slowing. There aren't the killer applications out there that there were in the past. That's not to say that they couldn't appear. One potential killer app we are watching closely is video file-sharing. That could create a new buzz.
Q: You've both been critical of the government's role in bringing this all about. How can the government remedy this?
Cleland: Chairman Powell at the FCC understands the problems and has a series of broadband deregulation rulings that are coming down the pike this year. The government is trying to reverse past FCC deflationary policies. But it is slow going. Essentially the government forced overall industry revenues down at an alarming rate. The government tried to create a CLEC industry and that has largely vaporized and cost investors tens upon tens of billions of dollars.
Q: Clearly, this has been bad for investors, but it seems pretty good for consumers.
Cleland: It is a two-edged sword for consumers. It is good in the sense that consumers are getting more wireless communication and more data cheaper. But it also results in lower quality because companies don't have the revenues or the profit to deliver high quality. It is troubling for industry innovation because when there is this much competition and trends are this negative, companies pull back on research and development. Potentially, we are about to lose a generation of technology and innovation. Consumers don't benefit from that.
Q: Yet it's in a company's interest to innovate, to differentiate and get some pricing power.
Cleland: If you have resources, if you have cash flow and your model is afloat you will still invest in R&D. But long-distance and the data-backbone transport companies and CLECs don't have enough money.
Whyman: The other element here is content. The reality is, most content holders are still terrified that if they put their prized content in a Web-accessible form it will immediately get replicated in a million copies all over the world. That's the other side of the problem of why people aren't buying broadband and why we aren't seeing demand in it: It is not compelling enough. Why isn't it compelling enough? Because the companies that are sitting on the content vaults aren't willing to open up those vaults because they don't have enough confidence that they will be able to keep control of it. I don't see a simple fix in sight.
Q: Let's talk about specific companies. Scott, where do you stand on WorldCom at this point? You were early in saying the Sprint deal wouldn't go through and they would need to find a new strategy.
Cleland: With its tracking stock MCI, WorldCom has played a shell game to try and create the illusion of growth. In a sense, tracking stocks are a very sophisticated form of misdirection. With one shell they say the WorldCom tracker last year grew at a 7% revenue growth rate. And with the MCI tracker, they pay a dividend, and show revenues declining at a 15% rate. They don't want you to add those trackers together, because then you would realize that WorldCom-MCI combined grew at a negative 1% rate of revenues in 2001. That was in an environment where the Bells grew revenues 2%-7%. It is hard to be a growth stock when your revenues are growing negatively.
Q: MCI is yielding about 40%, isn't it?
Cleland: The point we are making is that the tracking stock is the worst form of pro-forma reporting -- designed not to give you the entire picture. One must add the two together in order to get the numbers that are most important.
Q: Isn't this true of Sprint Fon and PCS Group as well?
Cleland: Yes. And AT&T is proposing to do a tracker of its consumer business. Anytime people see a tracker they should think of pro forma and they should ask themselves what it is they're being misdirected from looking at. There is a reason behind a tracker. And the reason is to divert attention from the negative to the positive. People still look at the trackers separately. They are making a big mistake. These are the same companies with the same networks and the same operations and financial wherewithal.
Q: What about Qwest? I noticed you've left that off your list of Bells. Last year, you ranked it up there with the others.
Cleland: Last year, we thought Qwest Communications and Sprint were prime takeover targets. We changed our view when we realized no one was willing to pay a premium for them because they don't offer any growth. They offer enormous business risk and huge debt liability. It doesn't matter how attractive the takeover is if no one is willing to take over the risk. The real troublesome issue for the nation is that Qwest and Sprint are the country's No. 4 and No. 5 local phone companies. They provide a lifeline telephone service to roughly 15 million American households. Those types of companies aren't supposed to be at financial risk.
Q: Great -- all the utilities are going bankrupt.
Whyman: In dark moments you start thinking about recession cartels. But that's extreme.
Cleland: The real mistake the government made in the Telecom Act of 1996 is that they thought their policy for competition had only upside. They tilted the regulatory playing field toward CLECs and their lousy business models by forcing incumbents to subsidize them. Now we are paying the piper for that very unwise regulatory policy of the late 1990s.
Q: What is your outlook for the economy, given your views on telecom and tech?
Whyman: If you could know any one number before you invest in technology, you would want to know how much corporations would spend on technology, including hardware and software and communications equipment. Historically, over the past 20-plus years, it has grown 11%. In 2001, for the first time since 1974, it shrank a whopping 10%. In 2002 we will get a cyclical improvement and some stabilization, but it is another year of weak growth. We are looking at roughly 2%-5% growth in corporate spending on hardware and software and telecom equipment, and that's half trend. Then you look throughout the economy and you say, "Who buys all this stuff?" Of the 62 sectors in the economy, the three largest ones, financial services, communication services and wholesale distributors, make up exactly half of all spending on tech and telecom and those three are in trouble. From the demand side, it is very hard to come up with a compelling scenario. So the short answer is, the economy stabilizes. We return to very weak growth. But it is another year of sub-trend growth. This is not a growth environment.
Q: Isn't there anything positive to say? Anything on the horizon?
Cleland: The FCC authorized a truly revolutionary technology on Valentine's Day, ultrawide band. This is Star Trek stuff. It has enormous and wide-reaching applications. This technology has been buried in the FCC for three years. And Chairman Powell and Commerce Secretary Evans twisted arms to get it to market. Because it is so revolutionary and it is so different from normal wireless technology, we think most people simply aren't aware of it or don't get it.
Q: How does it work, and how would it affect an average consumer?
Cleland: It allows for all sorts of consumer applications such as monitoring and remote sensing.
Whyman: But the big application is for short-distance wireless devices because it has a lot more bandwidth and uses much less energy . You can conceive of wireless local laptops that you can walk around the office with.
Q: Does it threaten existing technology?
Cleland: It is a very disruptive technology. Blue Tooth and 80211B are at risk. I can't believe I got that acronym right.
Q: That was good. But how is this good for the industry right now?
Cleland: The positive is, this is a new technology that will have a very steep demand curve. However, it is going to take awhile to roll it out. And while the FCC authorized it, it's taking a cautious stance, because of concerns by competitors that this new technology would create dangerous interference. Competitors like Qualcomm and Sprint PCS didn't want it to get out of the regulatory crib. It is a whole new technology that will trigger a whole new set of applications we haven't thought about before. It's a better technology and better standard and it will open them up to more competition.
Q: What about cable at this point?
Cleland: Cable enjoys the most benign regulatory environment in recent memory. And fortunately, it hasn't been hit with as much of the Enron contagion. It has a very robust infrastructure and it has great ability to exploit that infrastructure. We think cable has a very bright future. The cable companies have the best broadband infrastructure. Cable has 750 times the spectrum bandwidth of telecom's copper wire. A strong infrastructure with a very benign regulatory environment is a strong positive for cable. We envision the Comcast-AT&T merger getting done. It will face a good bit of opposition, but it is likely to get approved.
Q: On the satellite side, what about EchoStar-DirecTV?
Cleland: We think that merger is at significant risk of disapproval by the government. We think it is a pretty simple bread-and-butter antitrust case. The government will look at the facts and say this results in substantially less competition and conclude the marketplace will be better if it did not go through. You could argue it was a brilliant maneuver by [EchoStar chairman] Charlie Ergen. He snatched it away from Rupert Murdoch, who could have put the hammer to EchoStar competitively. He then gets to look at his main competitor, slow him down, and learn all of his inside tricks. If the deal gets blocked, he has to pay a break-up fee. But past experience suggests he generally doesn't pay those things quickly, so he won't have to tie that capital up anytime soon. It will be paid off over time. It is a huge competitive gain for him in the short term -- for just a little risk.
Q: Does Rupert come back?
Cleland: Yes. He will come back because we strongly believe the future is to vertically integrate Direct Broadcast Satellite with content. That's the only way it's going to be able to able to achieve its full value.
Q: Thanks a lot. |
