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Broken business models and crippling debt are the wages of greed, corporate crime, and misguided regulation By Peter A. Bernstein

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What’sWrongWithTelecom

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But what may have eluded you amid the barrageof plunging financial data and stories of lavishlifestyles are the fundamental reasons for thedownward spiral. After all, users today are payingfor wired and wireless services of unsurpassedvariety and utility. We are pretty clearly at thedawn of a networking era in which almost every-thing we use—and even wear—will be capable ofbeing interrogated and manipulated by means ofreliable, always-on, always available, two-waybroadband networks. The developed world, atleast, is on the path toward the full dis-tance-independent interactiveengagement of all our senses.

So why is the business of com-munications in such dire straits?The problem is a convergence offactors, each of which would havebeen quite serious by itself. Unfortu-nately, they came not singly, or even serially, but all at once.In so doing, they triggered what may reasonably be calledthe Telebomb.

Five costly sins

The Telebomb has five key ingredients: • Greed. Too many companies chased too few

customers and—to make matters worse—manywere using similar technology.

• Corporate crime. As the stupidity of some greed-inspired decisions emerged, some players misrepresented thefacts by lying about their financial health (often with theconnivance of the accounting and investment communi-

ties), thereby destroying investor confidence and cast-ing a cloud of mistrust over the entire communi-cations business.

• Misguided regulation. Policies that protectedincumbent phone companies but were

disguised as competitive reform, likethe Telecommunications Act of 1996 in

the United States, were the timingmechanism for the Telebomb.

• Too much debt. Global Crossing,WorldCom, Qwest, Deutsche Telekom, France Tele-

com, Lucent, Nortel, Verizon, AOL Time Warner, and othershave incurred a collective debt of almost US $2 trillion. Until

ever, since the modern communications industry began in the first half of the

19th century, has it been in worse economic shape than it is today. Through

much of last year, it was hardly possible to pick up a newspaper or business mag-

azine without finding a story about a bankruptcy or seeing another once-high-

flying magnate being deposed (or maybe even led off in handcuffs).

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that debt is somehow made manageable, communicationscompanies will find the financial markets closed to them.

• A broken business model. Although the Internet istruly a wondrous phenomenon, its sudden surfacing in anindustry accustomed to slow, carefully thought out ways ofmaking progress (and 30-year depreciation cycles) has sodisrupted business models that telecom companies aretoday giving away services that used to contribute might-ily to their revenue streams.

While all the elements are strongly linked, greed andcorporate crime are very tightly coupled. Along with mis-guided regulation, they represent categories of specificactions by individuals or groups. The debt problem andbroken business model are two critical outcomes of thoseactions, abetted, of course, by advances in technology. Andas ill luck would have it, they are ongoing, dynamic, fes-tering conditions that make cleaning up after the Tele-bomb very difficult. Reducing greed, crime, and bad regu-lations are essential first steps for reducing debt and fixingthe business model.

Each of the five ingredients is worth a brief analysis.

Greed is not good

Bear in mind that increasing the world supply of facilities-based service providers—that is, service providers that owntheir own networks—from several thousand to several tensof thousands did not significantly change the number ofcustomers from whom revenues could be extracted. Eachnew start-up carrier had to believe, and induce investorsand lenders (including equipment suppliers) to believe,that it would be able to wrest market share from thosewho held it.

Among their exhortations: incumbents won’t counter-react; the other guys don’t have our talent; and unique newservices will win the day and allow us to become profitablequickly. Unluckily for the start-ups, incumbents do knowhow to defend their turf; and lacking significant new tech-nology, the start-ups had little choice but to choose price astheir market differentiator. This proved destructive to every-one: capacity exploded as dumb money chased bad ideasand waited for the other guys to blink, and we are stillwaiting for those lucrative “new services” that customerswill find it impossible to do without. The result: ongoingoperating losses, crushing debt, a capacity glut, and seem-ingly endless price wars.

It seems inexplicable that one of the largest sectors andemployers in the global economy—the engine driving mostof the world’s nonagricultural gross domestic product—isnow not just broken but broke. Greed certainly playedmore than a minor role in this.

Corporate crime

“How do those guys do it?” That is what WorldCom’s com-petitors kept asking themselves as they followed that dis-graced company into the financial abyss. It turns out thatmisstating earnings to the tune of $9 billion was a great way

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JANUARY • Upstart telecom giantGlobal Crossing [left]files for Chapter 11 bankruptcy

• AOL reports quarterlyadvertising sales up72%—unnoticed arenumerous one-time andunusual deals

MARCH•AOL Time Warnerwrites off US $54 billionin “good will”

•Media giants RTLand Vivendi Universalreport 2001 losses of US $2.2 billion and$13.7billion

APRIL•Ericsson announceslayoffs of up to 20 000employees before 2004

•Williams Communica-tions files for bankruptcyprotection with $7.1billion in debt

•KDDI/AU Group’s 3Gservice launches in Japan.In one month, it will havethree times as manycustomers as DoCoMo’sseven-month-old service

MAY•Deutsche Telekom loses US $1.7 billion in one quarter

•Troubled German media giant Kirch Group’s KirchPayTV unitfollows its KirchMediaunit into insolvency

•Cable and Wirelessreports loss of $6.7billion for fiscal year.NTT’s loss is $6.5 billion

JULY•Warren Buffett buysLevel 3Communications andbegins snapping upailing telecom

companies•WorldCom files largest bankruptcy in U.S. history, $65 billion

•Vivendi Universal CEOJean-Marie Messier andBertelsmann CEOThomas Middelhoff are fired

AUGUST•Dutch company Royal KPN writes off US $8.2 billion, mainlyin 3G investments

•France Telecomsubsidiary Orange asksSweden for permissionto delay 3G service forthree years

•U.S. CEOs beginpersonally affirming the truth of financialreports under a new law

SEPTEMBER• A U.S. court rejectsBertelsmann’s bid totake over Napster[logo, left], which sooncloses its doors

•The EC lets T-Mobileand mmO2 share costsbuilding 3G networks inGermany and the UK

JUNE• Despite an annual loss of $19.3 billion, Vodafone CEO Christopher Gent receives a $2.2 million bonus

PHOTO CREDITS: (TOP TO BOTTOM): REUTERS, AFP, REUTERS, NAPSTER, SONERA

FEBRUARY•Satellite telephone company Globalstar files for Chapter 11bankruptcy

• U.S. Securities and Exchange Com-mission begins its inquiry into fiber-optic capacity swaps byGlobal Crossing, Qwest, others

2002: Liars, Losses & Layoffs

•Sonera’s CEO, Kaj-Erik Relander, is arrested for“gross violation” of Finland’s communicationsprivacy laws in 2000 and 2001

NOVEMBER •Sweden’s Telia ABmerges with Finland'sSonera [left]. The com-bined company is thelargest telecom-munications provider in Scandinavia

•Broadcom announcessupport for IEEE802.11g, still a draftstandard only; a numberof companies announceplans to buy the Broadcom chip set

DECEMBER

OCTOBER•The FCC rejects a pro-posed merger betweenthe two dominant U.S.satellite TV providers,EchoStar and DirecTV

•Prosecutorsinvestigate role thatTyco auditor Price-waterhouseCoopersplayed in theaccounting scandalsbesetting the conglom-

erate•WorldCom CFOBuford Yates and threeother high-levelexecutives plead guiltyto financial fraud felonycharges

•Tyco International chairman Dennis Kozlowski [left] is arrested for tax evasion

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to fool not just investors but also competitorsinto believing that it could be profitable to sellservices below cost. It was also a great way tofuel a price war as competitors broke the busi-ness model to compete with WorldCom, mak-ing things they once charged for either free orvirtually free.

Competitors also boosted their spendingon new equipment and mergers and acquisi-tions to chase the mirage. Now they havespent themselves into a quagmire of debt andin the process have acquired technology thatwill accelerate the crumbling of what is left of

the business model. For example, outfittingcomputers and next-generation handhelddevices of all kinds with the capability to carryvoice over networks based on the Internet pro-tocol may well sound the death knell formetered voice services. For another, the explo-sive growth of new wireless technologies likeIEEE 802.11 and Bluetooth make it possible toprovide ubiquitous broadband service overmeshed network facilities neither owned norcontrolled by traditional carriers.

Misguided regulation

In parts of the world (South Korea is the bestexample), the ubiquitous availability of inter-active broadband communications at reason-able rates is seen as essential to the develop-ment, and ultimately the competitiveness, of acountry. Not only does South Korea have thehighest penetration of wired broadband homesand businesses in the world right now, but itrecently committed to hooking up its entirepopulation by 2008. Contrast this with theUnited States, where public policy requires thatbroadband Internet access be treated differ-ently depending on whether it is delivered overcable or over traditional telephone facilities.

Regulation in the United States is based onthe belief that government can do better thanthe market to ensure universal availability oftelecom services at reasonable rates. But infact, the only thing that U.S. regulations seeminterested in ensuring is old-fashioned dial-tone service. Broadband utility service, whichmuch of the rest of the developed world viewsas a necessity, is left to the mercies of the mar-

ketplace—a marketplace that has turned outto be far from the competitive ideal.

This policy’s results are not encouraging.Within a year, over 85 percent of U.S. homeswill be passed by broadband lines—that is,they will be close enough to those lines to beconnected to them; yet only about 20 percentof these homes will actually order the service.On top of this, U.S. Federal CommunicationsCommission (FCC) chairman Michael Powelland Representative Billy Tauzin (R-La.), chairof the House Committee on Energy and Com-merce, now talk of granting further immuni-

ties to the very same regulated entities thathave failed to make broadband service uni-versally available.

To make matters worse, the same compa-nies that own the wires own the vast majorityof wireless assets. Lacking competitive pres-sure, they have little motivation to deploy next-generation wireless service, which requires avery substantial investment and in its presentform doesn’t seem to promise sufficientreturn on that outlay.

Revised regulations that mandate deploy-ment rather than protect incumbents are notonly viable, they may be the only way toensure the rapid distribution of local broad-band facilities at reasonable rates. In theUnited States, at least, it’s not just the indus-try that needs fixing: regulation does, too.

Too much debt

What happens when too many companieschase too few customers with too similar prod-ucts? When they believe that owning facilitiesis the way to own customers? When they areurged to buy communications infrastructurearound the world at grossly inflated prices?When the people urging them are fee-seek-ing financial advisors whose analysts, laboringunder a severe conflict of interest, are at thesame time touting to an unsuspecting publicthe creed that “prospects are unlimited, weare living through a valuation paradigm shift”?How about when equipment vendors eager toboost their sales (and market value) extendcredit to enterprises that cannot be deemedcreditworthy by any objective standard?

C O M M U N I C AT I O N S •O V E R V I E W

WishList

Inexpensive and faster

BROADBAND CONNECTIONS

everywhere, instead of just in

South Korea, Singapore, and a

few other countries

Single worldwide standards,

and lower costs, for 3G AND

HDTV devices

Pervasive implementation of

IPV6, a new Internet protocol

(IP) that would allow every

object in the known universe

to have its own IP address

Lightweight low-power

cellphone/PDA/digital

camera/MP3 HANDHELD

DEVICES that can roam

automatically across multiple

kinds of networks: Bluetooth,

IEEE 802.11, and 3G cellular—

and give people a reason to

spend more on their phone

service

Easy, effective SECURITY

TECHNOLOGIES for

wireless LANs and virtual

private networks

DarkHorse

A spinoff of a spinoff

(Lucent Technologies),

AVAYA has declining losses,

still-robust cash reserves,

and plenty of new technology

coming from a shiny new lab

with over 80 researchers.

If the company, which

specializes in enterprise

and corporate IP-based

and legacy phone systems,

hangs on for the upturn, it

could be a strong performer

in a profitable market

Regulations that mandate deploymentmay be the only way to ensure the rapiddistribution of local broadband facilities

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What happens is you get what we have:overcapacity, little spending on new equip-ment, companies defaulting on their financialobligations in previously unheard-of num-bers up and down the industry supply chain,a ton of finger pointing, and a bunch ofwealthy lawyers.

Bad as the other problems are, job No. 1 isto restructure the industry in order to managedown its $2 trillion of debt, to end the malaise.We are still early in the global industry- anddebt-restructuring cycle. Elements of the solu-tion will include: extensive industry consolida-tion as the strong cherry-pick the assets of theweak at steep discounts and force the elimina-tion of nonperforming assets; enormous write-downs of outmoded plant; spectacular bank-ruptcies of former industry stalwarts in theequipment and services sectors; massive gov-ernment intervention in countries whereincumbent financial ties remain strong (suchas the recently proposed $9 billion bailout ofFrance Telecom by the French government),and/or a complete forgiveness on the 3G auc-tion obligations. Indeed, the consensus ofindustry executives and observers is thatbefore things can get better, they are actuallygoing to get worse for the next few quarters.

The broken business model

Telecom’s unworkable business model willbe the subject of numerous business booksin the coming years. The easiest way tounderstand it is within the context of one’sown experience.

The world was once a place in whichscarce information was accessed over a fewexpensive monopoly networks like the BellSystem in the United States. Prices were high,and all but local services were metered, notprovided on a flat-rate basis. Into this settingentered all of the information technology andcommunications technology of the past 20 years. Much that was scarce became abun-dant. Information got digitized. Access to itproliferated, becoming inexpensive and com-modity-like. The communications industrylost its ability to charge for the things it hadalways charged for: time and distance in theform of voice minutes between specific geo-graphic locations.

In the telecom industry, metered voice hastraditionally generated the bulk of the profits.Data, despite now being the bulk of traffic,was and is only marginally profitable; it ismostly flat rate. Voice is moving in that direc-

tion, too. If the trend continues, what will paythe bills in the world of the future?

In cable TV, flat rates and advertising don’tcover the rising cost of content. Hence, thedesire of operators for pay-per-view and othermetered services. Video-on-demand and inex-pensive voice services are two possibilitiesthat spring to mind.

For the telephone companies, as men-tioned earlier, the prospects of sending voiceover data networks and uncontrollable wire-less deployment are frightening: the first takesthe biggest revenue source off the meter; thesecond could take traffic completely off thenetwork. The value of facilities managementwill continue to diminish as value shifts tothe nonmonopoly “intelligent” part of net-working. Technology might finish off whatgreed, malfeasance, and irrational businessand public policy behavior got started.

Is there hope?

The short answer: yes. All the clichés apply:“Nothing lasts forever,” “This too shall pass,”and so on. In fact, the industry is alreadyaddressing the timely issues of illegal and/orirrational behavior by individuals.

It is a question of when, not if, new indus-try leadership will restore trust by managingdown debt and producing positive serviceexperiences for customers, as well as positivefinancial ones for investors.

Fixing the business model is more prob-lematic. It will get fixed, to be sure, because ina world that is ever more network-centric,what the network does and delivers will alwaysbe valuable.

But figuring out exactly where that valuelies is still a challenge. When the dust settles,the surviving and successful players will bethose among the new and established playerswho figure out exactly what it is about a net-work that is most valuable, how they couldmaximize that value in their networks, and—most importantly—how they could best getpotential customers to recognize that valueand become willing to pay a premium for it.

Even the worst of storms dissipate as theymove into new waters, and bombed-out land-scapes almost always come back looking bet-ter than ever. But when they emerge from theshadow of destruction, they invariably lookdifferent. Old buildings disappear and newones take their places. There is every reason tobelieve that history will repeat itself in theaftermath of the Telebomb. •T

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UnsungHero

Digital cowboy DAVE HUGHES

has been using a variety of

spread-spectrum technologies

to connect rural communities in

Wyoming and Montana to the

Internet for over 15 years. By

putting libraries, one-room

schoolhouses, and farms online,

the retired Army colonel is a

model and an inspiration to

other wireless warriors

Under Fire

STEVE CASE, AOL founder

and current AOL Time Warner

chair, is increasingly isolated;

executives from the Time

Warner side are now firmly in

control. Expectations of solid

ad revenues have proven illu-

sory, and perhaps fraudulent;

AOL’s pre-merger accounting

methods are under investi-

gation. And it may have to

write off even more good

will, after reducing it by a

mind-bending US $54 billion

in 2002