Have the Overbuilders Overreached?

With this column, we introduce Cody Willard, a telecom and Internet infrastructure analyst at Visual Radio LLC, an advanced communications development company. He is also founder of Teleconomist.com, a Web site devoted to news and analysis of telecommunications stocks. As always, let us know what you think.

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One of the great debates in the telecom world today is the ultimate fate of the companies -- like Global Crossing (GX Quote - Cramer on GX - Stock Picks) and Williams Communications (WCG Quote - Cramer on WCG - Stock Picks) -- that are constructing so many high-capacity fiber backbones. Let's tackle this question by looking at the four issues involved with what are called the fiber-optic overbuilders:

1. Are the overbuilders creating a bandwidth glut?
2. How will the overbuilders' debt-heavy balance sheets affect their future?
3. Is there any differentiation among the long-haul carriers, including the overbuilders?
4. Are any investable companies in the long-haul business?

The overbuilders, along with their sell-side advocates, argue that innovative new applications and services will continually drive bandwidth demand -- much in the same way they drove CPU demand over the past two decades.

Their critics contend that all of the capacity put in the ground in the past few years is more than enough to meet market demand, and that prices are heading south far faster than what can be made up in volume.

There's some evidence to support the critics. Prices have been dropping as so much capacity has come online over the past few years. There is every reason to expect this trend will continue, as the overbuilders begin to compete for new business by undercutting one another's pricing. Level 3 (LVLT Quote - Cramer on LVLT - Stock Picks), for example, openly predicts that its prices for various high-speed services will drop by 20% annually.

And yet the potential revenue sources, such as voice-over-IP (VoIP), IP video (both broadcast and on-demand), generic Internet access (both high-speed and dial-up), peer-to-peer applications and many other services, are gaining marketplace momentum -- and increasing bandwidth use. These services and applications -- and many new ones from videoconferencing to holographic video imaging -- will continue to boost bandwidth demand. RHK, a market research and consulting firm, estimates that Internet traffic in North America will increase from 350,000 terabytes per month (each terabyte equaling 1 trillion bytes) in 1999 to 16 million terabytes per month by 2003.

That's why I can confidently say that there are no present and no future bandwidth gluts.

A Coming Price War

But pricing is another matter. Many of these companies have overextended themselves by borrowing billions of dollars to build out their networks. Up until very recently, both private and public capital markets have been indulgent lenders to the overbuild industry. But now that the supply of capital is drying up, companies no longer will be able to rely on lenders to finance their burgeoning interest costs, much less continue the expansion of their networks. With the interest rate on low-grade telecom debt at 15% to 20% a year, these companies won't be able to borrow additional funds in the junk-bond market. Nor will raising money in the equity markets be an option, with their weakened balance sheets.

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The result? The more thinly financed players will fail to generate enough operating cash flow to cover the interest costs on their debt. It's unlikely larger telecom companies with positive cash flow and/or earnings will acquire such distressed companies, as they won't want to taint their balance sheets or dilute their operating results. What happens then? Expect to see the marginal overbuilders fold. But before they do, they'll cut their prices, thus hurting all of the players.

This effect will be amplified by one fundamental truth underlying the entire industry: Bandwidth is a pure commodity. There is virtually no difference if data is transported over Broadwing's (BRW Quote - Cramer on BRW - Stock Picks) or AT&T's (T Quote - Cramer on T - Stock Picks) or WorldCom's (WCOM Quote - Cramer on WCOM - Stock Picks) backbone. So pricing cuts by some affect all.

The one positive is that bandwidth demand follows a highly elastic demand curve, which means that a small reduction in price results in a large increase in demand. For this reason, the revenue of the remaining overbuilders likely will continue to grow quickly.

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Find out what other challenges the overbuilders will need to overcome in Part 2 of this column.