Investing in communications stocks is not what it used to be. Modern investors are participants in the culmination of a revolution in the delivery of voice, video and data services started more than 10 years ago, when the consent decree split up American Telephone & Telegraph Co. and formed the regional Bell operating companies.
Technological progress and rapid advances in our understanding of regulated industries and monopolistic markets are driving the pace of change.
Segmented out, local telephone exchange monopolies are fading rapidly, while real price competition in the domestic long-distance services is regarded as inevitable. The emergence of cable telephony as a supplemental, competitive force in local telephone service and access, a reality in the United Kingdom, is virtually assured by the recently announced alliance between Sprint Corp., Tele-Communications Inc., Comcast Corp. and Cox Cable. Wireless telephony has grown at an astonishing pace, and has spawned wireless data and cable industry segments; it is only 11 years old.
After AT&T's $12.6 billion purchase of McCaw Cellular Communications Inc., the rise of Nextel Communications Inc., and an alliance between AirTouch Communications Inc., Bell Atlantic Corp., NYNEX Corp. and U S WEST Inc., notions of a wireless local loop no longer seem unrealistic. In fact, satellite networks such as Motorola Inc.'s Iridium, TRW Inc.'s Odyssey, Inmarsat, Globalstar L.P. and Teledesic will attempt to take wireless global, offering anytime-anywhere service.
Digital compression technology and broadband infrastructure upgrades will accelerate these changes, as well as help introduce a host of new products and services to business and residential consumers alike.
Investors must think of the communications industry in a new light. In place of the mature industry that once existed, an emerging industry has been born, with all of the attributes that differentiate emerging from maturing industries: technological, regulatory and strategic uncertainty; a risky demand side; and high capital intensity.
Defining the universe
Until recently, communications investors had only to make a decision between local exchange companies and interexchange carriers. Now, the landscape is littered with competitive access providers, cable companies, independent wireless carriers, satellite services and capacity resellers, each with the potential to offer some form of video, voice and data service. Even the regional Bell operating companies cannot be regarded as pure voice plays anymore: new market entry awaits only the removal of regulatory restrictions.
Competitive access providers, competitors of relatively recent origin, overbuilt advanced fiber optic networks in a number of large and midsized cities. They offer enhanced delivery services at a cheaper price, and enable customers to avoid heavy local exchange company access charges that account for more than 22% of the LECs' revenue. In effect, their presence ended the local exchange monopoly for large-end users.
In long-distance service, a second tier of carriers, led by LLDS Communications Inc., ALC Communications Corp. and LCI International Inc., remain viable investments and are followed by yet a third tier, known as resellers, who buy up access in bulk at discount prices from the larger carriers.
The burgeoning wireless communications industry has complicated matters further by splitting itself into a number of subindustry segments. These subsets - which include cellular, enhanced specialized mobile radio, paging and wireless cable and data services - are home to a number of stocks. Some like Nextel and McCaw Cellular are national, while others such as Centennial Cellular Corp. are regional. Many are independent, although a number of prominent firms, such as United States Cellular Corp. and Lin Broadcasting Corp., are owned by even larger communications companies.
Personal computers increasingly are recognized as a promising conduit for two-way communications systems. Some predict the PC, not the television, will be the dominant delivery mechanism for interactive video services. If so, the computer and telecommunications industry might become so integrated as to become indistinguishable. The number of recent alliances between communications and computer firms indicates such a convergence already might be under way.
Alliances of EDS Corp. and Sprint; Novell Inc. and AT&T; Intel Corp. and Cable News Network Inc.; and Intel, TCI and General Instrument Corp., are among the alliances promoting the use of computers rather than televisions for communications purposes.
Software manufacturers also are a necessary ingredient in the communications mix. Microsoft Corp. is an active player, announcing joint ventures with Mobile Telecommunications Technologies Corp., General Instrument, Metricom Inc., and Nippon Telegraph and Telephone Co.
Microsoft's alliance with MTEL will compete with Ardis (a partnership between RAM Broadcasting Corp. and BellSouth Corp.), Nextel, U S WEST and AT&T in a wireless data market expected to grow to 20 million subscribers and $2 billion in revenue by 2000.
Questions about delivery system capabilities, standards and expenses induce careful implementation deliberations on the part of network providers. Big orders come in slowly; the whole process runs in fits and starts, causing stock prices to move sharply but intermittently. Nextel, for example, has suffered significant share depreciation based on uncertainties associated with its wireless capabilities.
Standardization difficulties enhance fears of obsolescence. They also are a major cause of delays in infrastructure investment. These delays in turn hold up the services intended to move through the new delivery networks. While standardization difficulties in some industry subsets have been alleviated, in the emerging wireless data and voice industries, standardization problems may serve to delay the implementation of fully integrated, national wireless networks, in effect limiting industry potential in the short run.
Telecommunications equipment stocks, the equity values of which are so heavily influenced by large orders, are the heart of technology debates. For many of the smaller equipment companies, orders can result in huge stock swings depending upon on which side of the selection process they end up.
Orders in the hundreds of millions of dollars can leverage earnings at companies known for innovation rather than size. A single contract can move a company from a $500 million to a $1 billion market capitalization almost overnight. Prices can move the other way, too.
Uncertainty in local loop architecture, the primary area of communications infrastructure investment, has been the fundamental factor in the volatility in a number of local loop equipment manufacturers, including Broadband Technologies Inc., Northern Telecom Inc., ADC Telecommunication Inc., DSC Communications Corp. and Telefon L.M. Ericsson.
Risky demand side
Technological uncertainty also breeds indecisiveness among consumers because they react to the same fears service providers do when making purchasing decisions. When product life cycles are short and the threat of obsolescence is strong, consumers tend to exert real caution where any large up-front purchases are necessary. This condition is exacerbated when a large number of consumers are first-time buyers.
Direct broadcast satellite services, which are up and running on a national basis, will have to dispense with such concerns to enjoy any significant success.
In a series of trial runs both here and abroad, individual companies are testing the technologies and products of the future to ascertain consumer demand. Interactive trials are taking place in more than 12 U.S. cities, while numerous others await Federal Communications Commission approval. Early results, for the most part, have been disappointing. Comparatively, more than $1 billion was lost in the 1980s when a number of less ambitious information service and interactive trials failed.
Overall, cable telephony services have been subject to the most serious examinations. Introduced in the United Kingdom, the most competitive telecommunications market in the world, cable telephony has proven successful, attaining admirable penetration rates. While the U.K. market is not consistent with the U.S. market, service providers will benefit from the experience. U.S. trials, however, have been seriously contested. Because of weaknesses in sampling technique and technology, they may very well end up raising more questions than they answer.
It seems peculiar to think of communications as an industry with no rules, a definite attribute of an emerging industry, for its current regulatory structure is probably its most defining attribute.
From the 1934 Telecommunications Act, to the consent degree of 1982, to the host of FCC rulemakings and consent decree waivers that have come about during the past 12 years, regulation has dominated corporate strategy and investment decision-making. But the rules that will govern operations into the next century have not been established. The uncertainty created is a cloud that hangs over the head of all of the stocks in the communications universe.
Communications regulation is a three-horned beast. Oversight is the responsibility of the state and federal government as well as the judiciary. The influence at each level is fluid, and is currently undiscernible. Federal legislation was defeated in the 103rd Congress, and much of the debate seems to be moving to the states. The judiciary branch will continue to assert an active role. Constitutional challenges to communications regulation are now commonplace and a motion to vacate the consent decree, a litigatory initiative instigated by four regional Bell operating companies, has been presented to U.S. District Judge Harold Greene.
The significance of the motion to vacate has been overlooked by most observers. Overall, the regional Bell companies' willingness to use litigation as a corporate strategy has shown no signs of abating.
A firm's cost of capital is a decisive determinant of its investment behavior. Simply put, the higher a given firm's cost of capital, the higher the necessary rate of return on any given project. In industries like telecommunications, where heavy R&D costs and large sunk costs are a reality, any firm's cost of capital may be its most important attribute.
Regulation may induce, as well as enhance, pre-existing cost of capital differentials. Rate regulation, such as that in the 1992 Cable Act and the cable rate cuts that ultimately followed, did just that. Time Warner Inc., for one, is reporting cable cash flow is down 9% this year.
When one industry segment suffers such an abrupt change in its cost of capital, opportunities are granted not only to those in its immediate market, but to those competitors in markets in which the firm wishes to gain entry. The above-mentioned regulatory initiatives against the cable industry have exacerbated the current capital differentials among cable and telephone firms, and have skewed the competitive balance. Such industry-specific asymmetric regulation can undermine the chief goals of today's deregulatory efforts: infrastructure investment, competitive access and the promotion of industrywide competition.
Access to affordable capital also is recognized as a primary factor affecting the valuation of the wireless cable industry and is motivating a number of the alliances that have been announced in advance of next month's spectrum auctions.
There are discernible differences in competitive strategies being implemented across and among communications industry segments. Some recent examples in wireless, cable and international markets are explanatory.
Wireless. A number of significant events come to mind: AT&T's merger with McCaw; MCI's investment and disinvestment in Nextel; Pacific Telesis Group's spinoff of its cellular operations into AirTouch (a company with a market value equal to Sprint); the recently announced combination of the cellular operations of Bell Atlantic, NYNEX, AirTouch and U S WEST; and the Sprint alliance with ComCast, TCI and Cox Cable.
While each is different in its specifics, together they signal the importance of economies of scale and scope in high-growth wireless markets. For Pactel shareholders, the spinoff - while controversial - has been profitable. In the past 18 months, the value of a pre-spinoff Pactel share has risen more than 40%, more than any other regional Bell operating company.
It also was a defining moment in the history of regional Bell investment in wireless, which as been rather irregular. For example, Southwestern Bell Corp. and BellSouth each derives more than 25% of earnings from cellular services, while the cellular operations of NYNEX and U S WEST make up less than 13% of their total company value. The consequences of these alliances remain to be seen.
Cable deals. The idea of merging the operations of a cable company with those of a local exchange network represents a strategy that has fallen out of favor. Widely heralded as brilliant, synergies thought to exist between cable companies and the local exchange companies were supposed to usher in an era of interactive services and local loop competition.
In the wake of their collapse, the cable industry has instead chosen consolidation. This consolidation, called clustering, negates the uncertainties and substantial earnings dilution that inevitably would have followed the earlier blockbuster deals and negates the type of losses experienced by Bell Atlantic and TCI in the weeks following the announcement of their - ultimately aborted - merger. Only U S WEST, Time Warner and Southwestern Bell, which is shopping around the only cable system it bought, remain as reminders of that tumultuous time.
International. U S WEST shareholders might be surprised to learn they also are joint partners in a joint-stock company that Russia is forming to develop its national telephone network. Bell Atlantic and Ameritech Corp. shareholders might be equally surprised to learn they own a part of Telecom Corp. of New Zealand, which operates in the only market in the world in which two overlapping local exchange companies compete head to head for local and inter-exchange services. The competition - Clear Communications Ltd. - is owned by MCI and BCE Inc. Such investments represent the increasing interest domestic carriers have in international markets.
Cross-border investment is reciprocal: Bell Canada International, a unit of BCE, purchased a 30% stake in Jones Intercable Inc. for $261 million, and British Telecom has spent $5.3 billion for a 20% stake in MCI. In addition, Sprint recently sold a 20% stake to France Telecom and Deutsche Telekom. In response, AT&T has announced an investment in Unisource, a consortium owned by Dutch, Spanish, Swedish and Swiss telephone companies. If the foreign ownership restrictions imposed by the 1934 Communications Act are eliminated, this process will accelerate at an even faster pace.
The link between telecommunications and development, as well as an increasingly competitive global marketplace, has forced the liberalization of a host of state-owned companies. Argentina, Belgium, Chile, Denmark, Greece, Italy, Japan, Portugal, Spain, Thailand and Venezuela have privatized or are in the process of privatizing their state-owned telecommunication companies. Telefonos de Mexico S.A., Mexico's telephone monopoly, recently finalized a $6.73 billion privatization. In conjunction with a record number of domestic public offerings, these privatizations are flooding the world's capital markets with telecommunications equity.
In the move from monopolistic to competitive markets, Mexico is at the forefront. It has become a virtual magnet for cross-border investment. The privatized Telmex is now controlled by Southwestern Bell, Grupo Carso S.A. de C.V. and France Telecom. Bell Atlantic has a $520 million, 23% stake (with an option to go as high as 43%) in Grupo Iusacell S.A. de C.V., Mexico's largest cellular company. Grupo Iusacell will compete with Telcel (Telmex's cellular subsidiary), Grupo Domos S.A., Baja Celular Mexicana, Grupo Pulsar and a new joint venture between Motorola and Grupo Protexa S.A., in the lucrative Mexican wireless market. BellSouth is reported to be in talks with Grupo Domos, which has a 49% stake in Cuba's national telecommunications company and is one of Mexico's largest financial companies. Motorola also has a 42% stake in Baja Celular. MCI has aligned itself with financial group Grupo Financiero Banamex Accival S.A. in a $1 billion alliance to build a long-distance network in Mexico, and Sprint has acquired a stake in a long-distance joint venture with Grupo Iusacell. AT&T has yet to announce its Mexican strategy. Telmex's volatility is a testament to the forces affecting the Mexican telecommunications market.
Investing in markets moving from monopoly to competition is not an easy task. With the added burden of a complex regulatory scheme and changing technologies, the difficulty increases exponentially. Fundamentals and strategic vision are equally necessary. No longer can investors be inattentive to communications positions, especially when holding shares in incumbent carriers. Otherwise, they may be caught holding uncharacteristically risky stocks in companies that operate in a vastly changed industry.