How do you tell the difference between the companies that are going to survive the shakeout among telecommunications service providers and those that will go belly-up?
How about looking at each company's ability to execute a survival strategy out of Business 101?
Every CEO running a phone company has studied the problem. When some number of customers stops buying, a company's remaining customers often come looking for discounts. It's exactly this double whammy of falling demand and falling prices that has hit telecommunications providers from
And every CEO knows the textbook solution: Cut prices and grab market share. That, of course, can make the pricing problem even worse, so they make a cost-cutting plan to keep margins from falling through the floor.
Does that two-part strategy work? Yes, if the drops in demand and price aren't too big and don't last too long, but no, if revenue goes into free fall and big debt payments are coming due soon.
The View From Verizon
I'd put a company like Verizon in the first category. The dominant local phone company from Maine to Virginia and one of the healthiest in the sector, Verizon is suffering from the drop in demand.
The number of local telephone lines in service at Verizon actually fell by 2.7% in the first quarter of 2002. That's worse than the 2.1% drop in the fourth quarter of 2001. Revenue in the company's core local telephone segment fell 4% in the period. All that resulted in a loss of $500 million in the first quarter.
So on the day Verizon announced these results, the company also reported that it would cut another $1 billion from its 2002 capital spending budget. The company still has more wiggle room to cut capital spending further if sales keep falling, said CFO Fred Salerno.
And on the demand side, Verizon reported that it had added 186,000 new wireless phone customers during the quarter, down from the 518,000 new wireless customers added in the first quarter of 2001.
The stock market wasn't happy with the number, but it wasn't as bad as it appeared because the drop was attributable, in part, to customers shifting services to wireless from land-line connections. Owning a wireless business gives Verizon an effective way to fight for market share. And by cutting its prices in the highly competitive wireless market, but keeping its prices stable in the wired market, Verizon can also attempt to keep its average price relatively high.
Qwest: A Definite 'Maybe'
A company like
belongs in an intermediate group between a clear "yes" such as Verizon and an almost certain "no." Call it a "maybe" that will survive after selling off some of its best assets.
Qwest is a hybrid of a former regional Bell, US West, acquired by Qwest, and Qwest, a next-generation telecom service provider that set out to target data, Internet and long-haul long-distance markets. The old regional Bell half of the business is suffering through a downturn that looks much like what Verizon is experiencing. The old US West, which makes up about 80% of total revenue, will suffer a 0.4% drop in consumer revenue and a 14% drop in commercial revenue in 2002, according to estimates from Robertson Stephens.
And the other half of the business, the former Qwest growth businesses, will show a drop of about 11% in 2002. Profit margins here, even using EBITDA accounting (earnings before interest payments, taxes, depreciation and amortization), are razor thin -- just 5%, Robertson Stephens calculates.
This dynamic makes executing the cost-cutting strategy essential, but difficult, it turns out. The company has cut spending so deep that there is no room to cut further without harming service.
Nevertheless, the company has announced further cuts in headcount. In addition, the company has lopped off another $400 million to $600 million in capital spending. Projected spending is now $3.1 billion to $3.3 billion in 2002, down from original projections of more than $6 billion.
If that was all Qwest had to fall back on, I'm not sure the company would earn even a "maybe." But the company has created substantial balance-sheet breathing space recently. And the sale of the ultimate old-time Ma Bell asset, its Yellow Pages division, should raise $8 billion or so in cash.
Qwest has renegotiated its debt covenants, raised $1.5 billion by selling notes at a coupon of 8.75%, and begun to securitize (i.e., sell) about $500 million to $1 billion of receivables. (That turns these IOUs from customers into cash -- at a price, of course.)
But that wouldn't really make much of a dent in Qwest's $25 million in debt without the planned sale of the Yellow Pages business that Qwest acquired along with US West.
is selling its Yellow Pages business as well, and that could depress the price of both assets, but analysts still expect Qwest to clear better than $8 billion.
So if Qwest is a maybe, what companies earn a "no"?
What to Make of WorldCom
WorldCom, for one, could be a potential victim, especially when you factor in how breathtakingly fast prices are collapsing in the next-generation telecom services of data, Internet and/or long-haul long distance.
For example, in January 2001, the wholesale price of a one-year forward contract for an OC-3 grade connection between New York and Los Angeles -- that is, a contract to deliver in a year enough network capacity to carry 2,400 simultaneous phone conversations -- came to $26,000, according to investment banking firm Stephens Inc., no relation to Robertson Stephens. By November that contract went for $3,000.
Adding to its woes, revenue continues to fall at WorldCom's consumer business,
. But in the WorldCom Group piece of the whole, the company seems to be facing quickly falling prices in the core data and Internet businesses.
I say "seems" because the existence of the two tracking stocks and business units gives WorldCom considerable flexibility to shift its allocation of costs inside the company. The accounting at WorldCom is hard to understand.
If falling prices and demand were WorldCom's only problems, it might skate by, but what makes its problems so pressing is its $25 billion in long-term debt. Between $1.5 billion and $4.5 billion of that debt matures each year, beginning at the end of 2003, according to Morgan Stanley. The company clearly has a limited time to fix its problems.
And the likelihood that the debt will face further downgrades from the rating agencies (it's currently rated Baaa1/BBB-) just increases the pressure on the stock. The likelihood is that WorldCom will muddle through, but it's by no means a certainty.
Two "outside" factors have the power to shift the odds for or against any specific telecommunications service provider: changes in government regulation and the speed of technological change.
First, regulation. In early 2002 the New York State Public Service Commission ruled that Verizon must lower the rates it charges to competitive carriers for local lines. The ruling doesn't take effect immediately -- changes in telecommunications policy move at a glacial rate.
But the long-term trend does point to lower prices charged to companies such as
and MCI Group by companies such as Verizon and
. Many analysts believe that competitors will gain as much as 30% of the local phone market over the next 10 years. I'd be more inclined to believe that estimate when this ruling leads to national changes in rates.
Second, technology. Remember that $3,000 OC-3 estimate from Stephens? Well, newer technologies than OC-3 have driven the cost even lower. An OC-48 connection with 16 times the capacity of an OC-3 costs only a little over four times as much as the older connection by November.
A customer who rode the cost of an OC-3 contract down in 2001 and then switched to the newer technology would have cut costs by 97%, Stephens figures. And OC-48 is not the cutting edge in capacity any more. The capital spending crunch in the telecom sector has slowed the deployment of even faster standards, but even so, the newest dense-wave division multiplexing products are being installed in networks. And that technology will drive the cost of bandwidth even lower.
New technology that creates cheaper bandwidth and that drags out the price recovery in this sector will make stronger balance sheets more important than ever in separating the "yes" from the "no" companies.
A new Jubak's Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBC's Business Center most Wednesday nights at approximately 5:45 p.m. ET. At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Intel, Microsoft and Nokia. He does not own short positions in any stock mentioned in this column.