By Kevin Maney

The telecommunications industry is stuck in the equivalent of an Indiana Jones movie. It might escape one trap, but behind that lie five or six others that seem even more deadly.

Bottom line: Telecom will get much, much worse before we see even a glimmer of a happy ending. Though that probably won't much affect consumers, it will hurt a wider circle of investors, induce more layoffs and reverberate through the economy, perhaps stalling a recovery.

The telecom meltdown already ranks as the biggest business debacle in U.S. history.

It surpasses the collapse of the railroads in the 1890s, the savings and loan crisis of the 1980s and the dot-com crash of 2000-01. By some estimates, more than $2 trillion of value in telecom stocks has been wiped out the past two years. In 2002 dollars, the S&L mess wiped out $250 billion in value.

Hard to believe this could get worse, but that's what most people in the industry forecast. "To paraphrase (Winston) Churchill, we're just at the end of the beginning," says telecom analyst Francis McInerney of North River Ventures.

"We haven't hit bottom yet," says Dan Hesse, a longtime telecom executive who now runs start-up Terabeam, which sends data using diffused lasers shot through the air. "I wish we were not in the same (telecom) ecosystem, but we are."

Why is telecom in such bad shape? Conventional wisdom calls telecom's wreckage a correction. Companies built too much capacity, anticipating demand that hasn't yet arrived, while investor enthusiasm carried stock prices to unsustainable heights.

But the conventional wisdom is only part of the problem. Other reasons go deeper:

• The waves play off each other. Problems in one part of the industry affect the other parts, because they are interlinked, causing a domino effect. One company's bankruptcy can force others.
• Technology keeps ripping apart telecom business models. The pace of change that has long driven the computer industry is finally hitting telecom, and many telecom companies hold old technology that's dragging them down.
• Telecom finance looks dire. Falling prices, huge debt and investors who wouldn't touch telecom with a mile-long pole add up to disaster.

Waves Crashing Ashore

The telecom mess is unfolding in waves. The canary in the phone line was the crumpling of telecom equipment makers such as Lucent Technologies and Nortel Networks in 2001. The second wave has been the devastation of long-haul carriers such as WorldCom, Global Crossing and Qwest Communications.

The next wave, many believe, will hit the older telecom giants such as AT&T, Verizon Communications and BellSouth. That wave might already have begun overseas. Deutsche Telekom, overloaded with debt and losing customers, is spiraling toward disaster. France Telecom seems close behind.

Then look for a fourth wave: the wireless industry.

The Domino Effect

In telecom, links between sectors wrap around each other.

Equipment makers sell to the long-haul networks, which carry data and voice traffic from one local network to another.

Wireless providers feed cell phone calls into local networks and out to the long-haul guys. And it all mixes together. Long-haul carrier Sprint, for instance, owns a major wireless company, Sprint PCS. And local phone companies are pushing into long-distance.

It's easy to see how trouble hit the equipment makers. As telecom companies crash, they stop spending on new equipment. So Nortel, for instance, lost $19 billion in the second quarter of 2001.

But the effects of the relationships can get subtle and dangerous. One example is the way the long-haul collapse will hurt local phone companies.

Prices for carrying traffic on a long-haul fiber network have dropped as much as 60% over the past year and will keep going down, analysts say. A wave of bankruptcies could push prices even lower.

The same price drops have yet to occur on local networks, but they will - as competition heats up. Financial firm Friedman Billings Ramsey says it costs 14,000 times more to carry a bit of information one mile on a local network vs. a long-distance network.

Gaps like that don't stand long in an open marketplace. As more companies provide local phone service, network costs will drop off a cliff, as they did when long-haul markets got more competitive.

Local phone companies are also losing consumers as wireless prices dive. Consumers increasingly buy cell phones instead of a phone line. About 18% of 625 cell phone owners in a recent USA TODAY/CNN/Gallup Poll said they used cell phones as their primary phones.

By 2006, Forrester Research estimates, 2.3 million U.S. households will replace regular phones with wireless ones. The shift, along with Internet telephony, will cost telecom giants $8.8 billion in annual revenue.

Overall, the loss of customers is slowing cash flow for local phone companies - and soon they could find they have more cash going out than coming in.

Worldwide, about $1 trillion in local phone company market value "is at risk," McInerney says.

Bankruptcies could cascade through one part of telecom after another. If WorldCom were to file for Chapter 11 bankruptcy protection, it would continue operating as a company and renegotiate its debt, getting rid of much of the burden of paying off that debt.

That would allow WorldCom to operate at lower cost and drop prices to beat competitors, which still wrestle with mountains of debt. Competitors such as Qwest and AT&T might then have to file Chapter 11 to get rid of their debt and create a level playing field.

"Once one company emerges (from Chapter 11), that puts pricing pressure on the other companies, and that almost forces them into it," says Hesse, who on Thursday cut 20% of Terabeam's workforce.

"The end game is that all the long-distance carriers go bankrupt," says Susan Kalla, analyst at Friedman Billings Ramsey. "If the name of the game is to wipe out debt ... it's likely they'll all take advantage of that."

So if WorldCom files for bankruptcy protection, the long-haul sector could go down like dominoes.

A Technology Squeeze

Telecommunications is also getting blindsided by the pace of technology change.
"For the last 30 years, the computer industry has been dealing with Moore's Law, and now it's telecom's turn," says Dana Blankenhorn, editor of telecom newsletter A-Clue.com. Moore's Law is behind the constant leaps in computing power for cheaper prices. In fact, new technology has created a couple of enormous problems for telecom companies. One of those disruptive technologies is dense wavelength division multiplexing, or DWDM.

Perfected in the past few years, it splits a beam of light in a fiber-optic line into wavelengths and crams data traffic onto each wavelength. DWDM can increase the capacity of a single fiber by 1,000 times.

WorldCom, AT&T, Qwest and other companies started building fiber networks five years ago, before DWDM. They built capacity based on what a single fiber could carry, not knowing it would increase so much. Long-haul companies spent $90 billion putting in networks - twice what the nation spent on schools in the same period.

Now, only 2.5% to 5% of the fibers in those networks are carrying traffic. Even though demand for data transmission keeps growing, DWDM technology keeps improving, and growth might never catch up to supply. The result: more downward pressure on prices, greater excess capacity and deeper financial trouble for carriers.

"Bandwidth is virtually unlimited, at least for the foreseeable future," says Robert Murray, a longtime technologist who worked in space communications before starting Web business Lawca.com. "WorldCom bit the big green weenie along with a dozen others because they all jumped on the fiber bandwagon five years ago."

Other parts of telecom will get whacked by an unfolding technology surprise: Wi-Fi, a supercheap, open-standard wireless technology, which is steadily increasing in capability while dropping in cost.

Wi-Fi can carry data traffic 10 times faster than a cable modem or DSL phone line but only over limited distances. Wi-Fi was intended to be used as a wireless data network inside a home or office building.

But soon, Wi-Fi will be able to carry data even faster - and farther. A start-up called Etherlinx has come up with a way to send Wi-Fi signals up to 20 miles. The developments make Wi-Fi look like it could become a serious contender in the business of wireless data and phone calls and could possibly match many of the capabilities of so-called 3G networks that are being built by major wireless companies such as Sprint and British Telecom.

Here's the kicker: Wi-Fi wireless spectrum is free. It's the same spectrum used by in-home cordless phones. But wireless giants paid $150 billion worldwide just to buy the spectrum for 3G, and it will cost them hundreds of billions more to build the networks.

Many in telecom believe 3G investments will pay off. Others believe it will be like HDTV - a beautiful technology that misses the mass market. If so, 3G will leave telecom players around the world with yet more debt and costly write-offs.

Wi-Fi "is just the tip of the iceberg," Blankenhorn says. "Eventually, every telecom company is going to have to get in line with Moore's Law." Those that don't will suffer the fate of old computer companies such as Control Data or Burroughs - dying off or becoming irrelevant. As that happens, expect more telecom pain.

The financial crunch

Then there's the financial hole telecoms have dug.

They basically can't raise or borrow money. Bad news keeps chasing away potential investors or lenders. Telecom stocks go nowhere but down. Bankruptcies leave creditors with major losses. The financial scandals at WorldCom and Global Crossing, and the recently announced Justice Department investigation of Qwest, have shaken investors' faith in numbers reported by telecom companies.

Distressed telecom companies can't even sell assets, especially hard assets like telecom networks. Global Crossing has been trying to sell its 100,000-mile fiber network but is finding few takers. The $500 million Level 3 raised is a move to take advantage of fire sale prices - but Level 3 wants to buy customer bases and traffic. CEO Crowe says that buying hard assets "is my lowest priority."

As the wave of disaster slams into local phone companies, they'll find that they're holding massive, expensive assets based on copper wires and outdated telephone circuit-switched technology. New networks are based on fiber or hybrid fiber-coaxial cable (HFC) lines and Internet-style packet-switching technology. Most likely, no entity will want to buy the old local networks, as new technology makes them worth less.

"Copper," Blankenhorn says, "is dead weight."

The economy isn't helping. Data and voice traffic is growing because consumers and workers increasingly use the Net, and cheap long-distance encourages more calls. "But the biggest grower of traffic is more employees and more computers on desks," Hesse says. The soft economy inhibits job growth. "If these doldrums last another 12 months, I don't know how many (telecom) companies can make it," Hesse adds.

Survivor Takes All?

Few are willing to predict when the telecom crash will end. Certainly, demand will keep rising, which works in the industry's favor. "Fundamentally, communications is not a discretionary investment," Crowe says. "You have to have it. Those (telecom) companies that get through this difficult period are going to have a real interesting time."

Still, demand can't pull the industry out of its pit until the bankruptcies, debt and technology problems get cleansed from the system.

How long will that take? At the industry's Supercomm convention in Atlanta every June, analysts always dole out forecasts. This year, they stayed mum. There is a telecom recovery somewhere down the road, but at the moment it seems beyond the horizon.

USA Today July 15, 2002

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